Avoid overpaying taxes on nondeductible IRA contributions

January 23, 2023

Tax time is not without its complications. And if, like many people, your traditional IRA holds a mixture of deductible (after-tax) and nondeductible (pre-tax) contributions, it’s important to track your contributions carefully to avoid double taxation of distributions. Why? Because the IRS treats distributions as a blend of pre-tax and after-tax dollars. If you treat distributions as fully taxable, you’ll end up overpaying — and no one wants that! Read on for an example and some other pointers to consider as you navigate your taxes this year.

Deductible and nondeductible contributions: an example

Dan, age 62, withdraws $40,000 from his traditional IRA on August 1, 2022. At the time, his IRA balance is $200,000, consisting of $50,000 in deductible contributions, $80,000 in nondeductible contributions, and $70,000 in investment earnings. On December 31, 2022, the IRA’s balance is $170,000 — $200,000 minus the $40,000 distribution plus $10,000 in additional contributions and earnings after August 1.

To ensure that his distribution is taxed correctly, Dan must calculate the portion attributable to nondeductible contributions. These are the contributions that were made with after-tax dollars and therefore aren’t taxable again. First, he takes the IRA’s year-end balance, $170,000, and adds back the $40,000 distribution, to arrive at $210,000. Next, he divides his nondeductible contributions ($80,000) by $210,000 and multiplies the resulting percentage (38%) by the amount of the distribution. The result — $15,200 — is the nondeductible portion of his distribution, which is tax-free. For purposes of future distributions, Dan’s nondeductible contributions are reduced by $15,200 to $64,800.

Now, we’ll be the first to acknowledge that this is a lot of math and can be kind of overwhelming if you’re not familiar; when it comes to taxes, it’s always wise to work with a tax advisor or a tax-prep service if you feel like you need some guidance. That’s what they’re there for!

What about multiple IRAs?

Be aware that, if you have several IRAs, including one or more that are funded exclusively with nondeductible contributions, you can’t avoid tax by taking distributions from those accounts. All your traditional IRAs are treated as a single IRA for tax purposes, so your distributions are deemed to be a combination of taxable and nontaxable funds, regardless of the account they’re withdrawn from.

The easiest way to track and report your deductible and nondeductible IRA contributions is to complete and file Form 8606, “nondeductible IRAs,” with your federal income tax return each year.

Be sure to visit with your accountant if you have questions about your IRAs and let us know how we can assist you, or you can also call or email Leslie and she’ll be happy to help.

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