Do you already make nondeductible contributions to a traditional IRA for yourself? If so, it’s important to understand the tax treatments of distributions in order to avoid being taxed twice on income that you are already contributing.
Substantiate Your Chosen Strategy
When it comes to contributing nondeductible amounts to an IRA, there are usually several reasons behind your decision to do so. If this is your chosen strategy, it’s important to justify the influencing factors:
- If you or your spouse already has a retirement plan through their place of employment and your total income exceeds the threshold, your IRA deductions may be reduced or even eliminated.
- Your current income may be over the qualifiable amount to contribute to a Roth IRA.
- You want to continue making the maximum contribution (currently $5,500 per year; $6,500 if you’re 50 or older) in order to take advantage of the benefit of tax-free growth.
However, it is important to realize that for this particular strategy to make sense, you must ensure that you will not be paying tax on IRA distributions of nondeductible (previously taxed) contributions. For this to be successful, you will be required to calculate the portion of each distribution that is attributable to deductible and nondeductible contributions and then use your federal income tax return to file Form 8606.
Making Sense of the Scenario
In order to better understand how this all works, picture this: You have $500,000 in your traditional IRA as of November 1, 2018. Of the balance that is currently available, $125,000 is attributable to deductible contributions, $200,000 to nondeductible contributions, and $175,000 to investment earnings within the IRA. You choose to take a $50,000 distribution from the IRA and report the entire amount as taxable income on your 2018 return. By doing so, you pay tax on this money a second time based on the portion of the distribution attributable to nondeductible contributions, which were already taxed in the years that you made those contributions.
To avoid this tricky double taxation, you must determine the portion of your distribution that’s attributable to nondeductible contributions. Let’s suppose the IRA’s balance is $475,000 on December 31, 2018 — $500,000 less the $50,000 distribution plus additional earnings after November 1. To determine the nontaxable portion of the distribution, you must add the $50,000 distribution to your IRA’s year-end balance (for a total of $525,000) and divide nondeductible contributions ($200,000) by that amount. You then multiply the resulting percentage — 38% — by the $50,000 distribution to determine what portion will be nontaxable ($19,000). Because $19,000 of your distribution has come from nondeductible contributions, those are reduced by $19,000 (to $181,000) for the purpose of future distributions.
Understand the Precautions
It is important to note that you can’t avoid your taxes altogether by choosing to make a nondeductible contribution to a completely different account and then taking a distribution from that particular account. For tax purposes, the IRS takes into account all traditional IRAs and treats them as a single IRA. So regardless of which account you choose, your distributions will still consist of a combination of both nontaxable and taxable funds. If you have any more questions, be sure to reach out to your CRI advisor.