After-Tax Balance Rules for Retirement Accounts

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After-Tax Balance Rules for Retirement Accounts

Taking after-tax withdrawals from a retirement account has advantages. If you meet certain requirements, the money withdrawn will be tax and penalty free.

Pretax vs. After-Tax Contributions

Most retirement plan participants finance their employer-sponsored plans with pretax assets, such as 401(k) and 403(b) qualifying accounts, or they claim a tax deduction for monies contributed to conventional IRAs. In both circumstances, these payments may assist to lower the individual’s taxable income for the tax year in question.

However, payments to employer-sponsored plans may be made after-tax, and contributions to IRAs can be nondeductible. The benefit of building after-tax assets in a retirement plan is that the amounts will be tax- and penalty-free when dispersed. This advantage, however, is only achieved if the appropriate measures are done.

Key Takeaways

  • After-tax assets distributed from a retirement account may be tax- and penalty-free provided certain conditions are met.
  • It is critical to maintain good records and communicate with your plan administrator and the IRS.
  • It is the responsibility of qualified retirement plan administrators to maintain track of which portion of your balance is after-tax assets and which is pre-tax assets, but it is your responsibility to do so for an IRA.

Tracking Your After-Tax Assets

To reap the advantages of this technique, careful recordkeeping and clear communication with your plan administrator and the Internal Revenue Service are required (IRS).There are various free (and fee-based) software applications available today to assist you in keeping track of your taxable and tax-deferred assets and income flows. An accountant may also assist you in ensuring that all of your ducks are in a row.

Your Qualified Plan Account

The administrator of your qualified retirement plan is in charge of determining how much of your balance is credited to after-tax assets and how much is attributed to pre-tax assets. However, it is beneficial to verify your statements on a regular basis to ensure that the tabulations reflect what you believe they should be. This gives you the opportunity to explain any differences with the plan administrator.

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Your IRA

Your IRA custodian is not obligated to maintain track of your IRA’s after-tax balance, and many, if not all, do not. As the IRA’s owner, you are responsible for maintaining track of such amounts, which you may do by completing IRS Form 8606.

Make careful to read the filing instructions that come with Form 8606 since they explain which portions of the form must be completed.

If you make a nondeductible contribution to your traditional IRA or roll over after-tax assets from a qualifying plan account to your IRA, you must submit IRS Form 8606 for the tax year in which the contribution is made. While the IRS does not presently require Form 8606 for after-tax rollovers, it is a good practice to record such sums for your records.

Form 8606 informs the IRS that the amount reflects after-tax assets and assists you in tracking the balance of your IRA that should be tax-free when delivered. Form 8606 must also be submitted for each year in which you receive distributions from any of your conventional, SEP, or SIMPLE IRAs and have after-tax funds in any of these accounts.

Taxing of After-Tax Assets

Qualified Plans

In general, the taxable percentage of funds disbursed from your qualifying plan account will be shown on the Form 1099-R you receive for the year by your plan administrator. If the amount on the 1099-R is incorrect, you should get written confirmation from the plan administrator of the part of the distribution that is due to after-tax assets. This will assist you in include the proper amount in your taxable income for the year.

IRAs

Your IRA custodian is not obligated to distinguish between the taxable and nontaxable portions of monies disbursed from your conventional IRA, with the exception of “return of excess contributions.” You must include that information on your income tax return by specifying the total amount of the payout against the taxable amount.

See the instructions for line 4a on page 1 of IRS Form 1040 for further information. Form 8606 will assist you in determining the taxable and nontaxable components of traditional IRA distributions.

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When taking distributions, all of your IRA accounts are considered as a single one, which means that the after-tax and pre-tax amounts in each must be pro-rated across all of them.

Pro-Rata Distributions

If your qualifying plan or traditional IRA contains after-tax funds, distributions will typically include a pro-rata share of your pretax and after-tax balances. All of your regular, SEP, and SIMPLE IRAs are classified as a single account for this reason.

Assume you contributed an average of $20,000 in after-tax contributions to your traditional IRA throughout the years, and your traditional IRA additionally has $180,000 in pretax assets due to rollover of pretax assets and deductible contributions. Your IRA distributions will comprise a pro-rata share of pretax and after-tax assets. Consider the following example using these numbers.

Example

John owns numerous IRAs, with the following balances:

  1. Traditional IRA No. 1, which contains his $20,000 nondeductible (after-tax) contributions
  2. Traditional IRA No. 2, which includes a $150,000 rollover from his 401(k) plan.
  3. Traditional IRA No. 3, which is really a SEP IRA, with $30,000 in SEP contributions

John takes out $20,000 from IRA No. 1. From the $20,000 he withdrew, he must add $18,000 as taxable income. This is because for the purposes of assessing the tax treatment of distributions when John has abasis (after-tax assets) in any of his conventional, SEP, or SIMPLE IRAs, all of John’s traditional, SEP, or SIMPLE IRAs are considered as one IRA.

The following formula may be used to calculate the amount of a distribution that is not taxable:

Basis ÷ Account Balance x Distribution Amount = Amount Not Subject to Tax

Using the figures in the above example, the formula would be as follows:

$20,000 ÷ $200,000 x $20,000 = $2,000

Because IRS Form 8606 provides a built-in method for calculating the taxable amount of distributions from conventional IRAs, you may not need to apply this calculation for IRA distributions.

Distributions from qualifying plan accounts with after-tax balances are normally pro-rated to cover amounts from both pretax and after-tax balances. As with IRAs, you cannot opt to distribute solely your after-tax amount.

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However, there are several exceptions. For example, if your account has after-tax balances earned before to 1986, these sums may be dispersed in full, making the whole amount non-taxable rather than pro-rated.

After-Tax Balance Rollovers

If your retirement account balance contains after-tax funds, whether or not these funds may be rolled over is determined by the kind of plan to which the rollover is done.

The rollover rules for these sums are summarized below:

  • All rollover-eligible funds may be rolled over to another IRA. This includes sums after taxes.
  • IRA to qualified plan: If the plan permits it, any rollover eligible funds may be rolled over to a qualified plan. This excludes after-tax funds, which cannot be rolled over from an IRA to a qualifying plan.
  • All rollover-eligible funds may be rolled over to a conventional IRA from a qualified plan. This includes sums after taxes.
  • Qualified plan to qualified plan: If the plan permits it, all rollover-eligible funds may be transferred to another qualified plan. This includes after-tax sums if the transactions are done as straight rollovers.

The Bottom Line

Keep in mind that this is just a summary of the regulations that apply to your retirement account’s after-tax balance. Understanding the regulations thoroughly will guarantee that you include the correct amount in your taxable income for the year you get a distribution from your retirement plan and that you do not pay taxes on sums that should be tax-free.

Consider seeking the advice of a tax expert to ensure that your after-tax assets are appropriately classified on your tax return and that you know which tax forms to complete each year.

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