Avoid Overpaying Taxes on IRA Distributions

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Avoid Overpaying Taxes on IRA Distributions

Are you concerned about paying too much tax on your IRA distributions? It’s a legitimate concern, but it’s one that you can solve if you have the correct facts. First, you must determine if your donations were pre- or post-tax, and to which sort of account. It is critical to have accurate records.

Key Takeaways

  • Most IRA contributions are made using pre-tax dollars, which means the funds are not taxed until they are disbursed or converted to a Roth IRA.
  • After-tax contributions to an IRA, on the other hand, are not taxed upon distribution or conversion to a Roth IRA since the tax has already been paid.
  • You cannot specify that you are making a distribution or a conversion using after-tax funds.
  • Instead, calculate the proportion of after-tax money in each of your IRA accounts and apply that percentage to the distribution to determine how much of it is taxable.

Income Levels and IRAs

Contributions to conventional IRAs are expected to be tax-deductible, but this is not always the case. Contributions to a conventional IRA are no longer deductible if you engage in a qualified retirement plan, such as a 401(k), and your income exceeds a threshold amount determined yearly for your filing status.

Contributions to a Roth IRA, of course, are always made with post-tax income if you qualify, and payouts from a Roth IRA are always tax-free. Unfortunately, you cannot have a Roth if your income exceeds a particular threshold.

Even if IRA contributions are not tax deductible, there are still compelling reasons to make them. They help you save for retirement, and the gains on these contributions are tax-deferred. (Remember that whether you make deductible or nondeductible after-tax contributions to an IRA, the yearly contribution maximum remains the same.)

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Traditional IRAs and Taxes

When you make tax-deductible contributions to an IRA, the monies in your account are not taxed until you withdraw them or convert them to a Roth IRA. If your IRA was constructed in part with nondeductible contributions, you won’t owe tax on the money when it’s disbursed or converted since it’s already been taxed.

You may believe that you may simply state that the monies you disbursed or converted were from nontaxable funds in your accounts, but the law does not allow you to do so. You must instead calculate the proportion of nontaxable money in your accounts and then apply it to the amount of the distribution or conversion. You must do this even if the IRA from which you are withdrawing funds contains solely nondeductible contributions. This necessitates maintaining detailed records of your after-tax contributions to your IRA.

Nondeductible IRA contributions must be reported on Form 8606, Nondeductible IRAs. Enter any current-year nondeductible contributions and add them to prior-year nondeductible contributions (excluding distribution adjustments) to determine the total basis across all of your conventional IRAs. This information assists you in calculating the tax on distributions and conversions. Make copies of Form 8606 to ensure you have cost basis information in the future. Don’t expect your IRA custodian or trustee to keep track of this information for you.

Maintain an annual running count of all your after-tax IRA contributions.

How to Figure Your Tax

When you have both kinds of traditional IRAs (tax-deductible and after-tax contributions), determining how much of your distribution or conversion is taxable is a tricky procedure. If the following explanation puzzles you, seek the assistance of an accountant or another skilled tax preparer.

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As previously stated, you cannot specify that your traditional IRA distributions or conversions are purely from after-tax contributions. Instead, you must calculate the proportion of your overall account balance that nondeductible contributions account for. Divide the total amount of your nondeductible contributions by the value of all your IRA accounts as of the end of the year (including SEP IRAs and SIMPLE IRAs). Include the distribution or conversion you are making, as well as any others you have made throughout the year, in that value.

If you contributed $10,000 in after-tax money to all of your IRAs throughout the years and the total value in all of your accounts plus the payout you are taking is $100,000 ($90,000 account balance plus a $10,000 distribution), your percentage would be 10% ($10,000 divided by $100,000). This percentage represents the tax-free portion of the IRA payout. Multiply the annual payout ($10,000) by this percentage to determine what is tax-free ($1,000); the remainder ($9,000) is taxable.

If you take a distribution before the age of 5912, you will be penalized 10% solely on the taxable component of the payout (assuming no penalty exception applies).The 10% penalty does not apply to the distribution’s tax-free part. In the above scenario, you would incur a $900 penalty (10% of $9,000).

In Case of a Loss

If you incur a loss on your account’s assets, you may realize the loss only after all of the money in your IRA have been dispersed to you. The loss is the difference between the amount disbursed and any remaining basis from nondeductible donations.

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Assume you contributed $10,000 after-tax to an IRA (assuming no deductible contributions) and the account is now worth $4,000. If you disperse the cash completely, you will incur a $6,000 loss. On Schedule A of Form 1040, the loss is claimed as a miscellaneous itemized deduction (you must itemize to get any tax benefit from the loss).

The Bottom Line

There are several compelling reasons to contribute to a nondeductible IRA, but doing so complicates your tax situation. Keep records so you don’t have to pay taxes on these contributions when you receive distributions or convert to a Roth IRA. If arithmetic isn’t your strong suit, consider hiring a tax specialist to calculate your tax liability.

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