Workers under age 70½ can deduct contributions to a traditional IRA, as long as they are not covered by an employer’s retirement plan. The same is true for those workers’ spouses.
If these workers are covered by an employer plan, they may or may not be able to deduct IRA contributions, depending on the worker’s income. However, all eligible workers and spouses can make nondeductible IRA contributions to a traditional IRA, regardless of income. Inside a traditional IRA, any investment earnings will be untaxed.
Dealing with IRA distributions
Problems can arise for people who hold nondeductible dollars in their IRAs when they take distributions. Unless they’re careful, they may pay tax twice on the same dollars – once by not deducting the contribution due to income limitations and again by not reducing their reported distribution for the nondeductible IRA contributions they made.
Example 1: Marge Barnes has $100,000 in her traditional IRA on February 15, 2017. Over the years, she has made deductible and nondeductible contributions. Assume that $25,000 came from nondeductible contributions, $45,000 came from deductible contributions, and $30,000 came from investment earnings inside Marge’s IRA.
Marge wants to take a $20,000 distribution from her IRA. She might report $20,000 of taxable income from that distribution. Indeed, Marge’s IRA custodian may report a $20,000 distribution to the IRS. However, a portion of her distribution should not be taxable due to the nondeductible IRA contributions Marge made to her IRA.
Cream in the coffee
To the IRS, a taxpayer’s IRA money must be stirred together to account for deductible and nondeductible contributions. Any distribution is considered to be proportionate. If Marge were to pay tax on a full $20,000 distribution, she would effectively be paying tax twice on the dollars included in this distribution that came from nondeductible contributions.
Example 2: After hearing about this rule, Marge calculates that her $25,000 of nondeductible IRA contributions was 25% of her $100,000 IRA value on the date of the distribution. Thus, she believes that $5,000 of the distribution (25% of the $20,000 distribution) represented after-tax dollars. Marge reports $20,000 of total IRA distributions and $15,000 of taxable IRA distributions on her tax return. But, this is also incorrect.
Year-end calculation
Tax rules require an IRA’s after-tax contributions to be compared with the year-end IRA balance, plus distributions during the year, to calculate the ratio of pre-tax and after-tax dollars involved in a distribution.
Example 3: Assume that Marge’s IRA holds $90,000 on December 31, 2017. Her $100,000 IRA was reduced by the $20,000 distribution in February, but increased by subsequent deductible contributions plus investment earnings. Therefore, Marge’s IRA balance for this calculation is $110,000 (the $90,000 at year-end plus the $20,000 distribution). This assumes no other distributions in 2017.
Accordingly, Marge divides her $110,000 IRA balance into the $25,000 of after-tax money used in this example. The result – 22.7% – is the portion of her distribution representing after-tax dollars. Of Marge’s $20,000 distribution, $4,540 (22.7%) is a tax-free return of after-tax dollars, and the balance ($15,460) is reported as taxable income. Marge reduces the after-tax dollars in her IRA by that $4,540, from $25,000 to $20,460, so the tax on future IRA distributions can be computed.
Correct reporting of nondeductible IRA contributions
As you can see, paying the correct amount of tax on distributions from IRAs with after-tax dollars can be complicated. Without knowledge of the rules, an IRA owner may overpay tax by reporting already-taxed dollars as income. And keeping track of after-tax and pre-tax dollars may not be simple.
The correct way to deal with this issue is to track pre-tax and after-tax IRA money by filing IRS Form 8606 with your federal income tax return each year that your IRA holds after-tax dollars. Our office can help prepare Form 8606 for you and prevent this type of double taxation.
The bottom line
The issue of tracking and reporting nondeductible IRA contributions is one of the big reasons why our office recommends to never throw away old tax returns. For example, if you made a nondeductible IRA contribution in 1996, your only proof that this contribution was not deducted is the copy of your 1996 tax return. For more information on record retention, see our Record Retention Guide.