Avoid overpaying taxes on IRA distributions

Worried about overpaying taxes on IRA distributions? It’s a valid concern but one that you can address if you have the right information. First, you need to know what kind of contributions you’ve made, before or after tax, and to what type of account. Keeping good records is key.

Key points

  • Most contributions to an IRA are made with pre-tax money, which means the funds aren’t taxed until they’re distributed or converted into a Roth IRA.
  • After-tax contributions to an IRA, however, are not subject to tax upon distribution or conversion into a Roth IRA, since that tax has already been paid.
  • By taking a distribution or making a conversion, you cannot designate that it was done with after-tax money.
  • Instead, you need to calculate the after-tax percentage of money in all of your IRA accounts and apply that percentage to your distribution, so you know how much is subject to tax.

Income levels and IRAs

Contributions to a traditional IRA are supposed to be tax deductable, but that’s not true for everyone. When you participate in a qualifying retirement plan such as a 401(k) and have income above a threshold amount set annually for your filing status, contributions you make to your traditional IRA are no longer deductible.

Of course, contributions to a Roth IRA are always made with after-tax income, if you’re eligible to make them, and distributions from a Roth IRA are always tax-free. Unfortunately, if you exceed certain income levels, you cannot have a Roth.

Even when IRA contributions aren’t deductible, there are still good reasons to make them. Your retirement savings increase, and earnings on these contributions are tax-deferred. (Keep in mind that the annual contribution limit to an IRA is the same whether you make deductible contributions or after-tax non-deductible contributions.)

Traditional IRAs and taxes

When you make tax-deductible contributions to an IRA, the funds in your account won’t be taxed until you withdraw them as a distribution or convert them into a Roth IRA. However, if your IRA was built in part with non-deductible contributions, you don’t have to pay taxes on that money when it’s distributed or converted, since it’s already been taxed.

You may think you can simply say that the funds you distributed or converted came from the non-taxable money in your accounts, but the law doesn’t allow you to do that. Instead, you need to calculate the percentage of non-taxable funds in your accounts and then apply that to the distribution or conversion amount.

Be sure to keep a running total of all your after-tax IRA contributions from year to year.

You must do this even if the IRA you take the distribution from contains only non-deductible contributions. This requires you to keep a good record of what you’ve contributed to your after-tax IRA.

When you make a non-deductible IRA contribution, report it on Form 8606, Non-Deductible IRAs. Enter any non-deductible contributions you make for the current year and add them to your non-deductible contributions in prior years (minus adjustments for distributions) to get the total basis of all your Traditional IRAs.

This information helps you understand the tax on distributions and conversions. Be sure to keep copies of the 8606 form so you will have information on the basis of costs for the future. Don’t assume that your IRA custodian or trustee will keep track of this information for you.

How to calculate the amount of taxes

When you have both types of traditional IRAs (those with tax-deductable contributions and those with after-tax ones), figuring out how much of your distribution or conversion is taxable is a complicated process. If the following explanation confuses you, it’s worth enlisting the help of an accountant or other experienced tax preparer.

As noted above, you cannot designate your traditional IRA distributions or conversions to come solely from your after-tax contributions. Instead, you need to figure out the percentage that non-deductible contributions represent in the total balance of all your accounts.

Divide the total amount of your non-deductible contributions by the value of all your IRA accounts (including SEP IRAs and SIMPLE IRAs) at the end of the year. Be sure to include in that value the distribution or conversion you’re making as well as any others you’ve made during the year.

For example, if you’ve contributed $10,000 in after-tax money over the years to all of your IRAs and the balance in all of your accounts plus the distribution you’re taking is $100,000 ($90,000 in account balance plus a distribution of $10,000), your percentage would be 10% ($10,000 divided by $100,000). This percentage is the tax-free percentage of the IRA distribution. Multiply the distribution for the year ($10,000) by this percentage to determine what is tax-free ($1,000); the balance ($9,000) is taxable.

If you take a distribution before the age of 59½, you are subject to a 10% penalty on the taxable portion of the distribution only (assuming no penalty exceptions apply). The 10% fine does not apply to the tax-free portion of the distribution. In the case of the example above, you would pay a $900 penalty (10% of $9,000).

In case of loss

If you have an investment loss in your account, you can acknowledge the loss, but only when all of the funds in your IRA have been distributed to you. The amount of the loss is the excess of the amount distributed less any residual base of non-deductible contributions.

Let’s say you made after-tax contributions to an IRA of $10,000 (assuming non-deductible contributions) and the account is now worth $4,000. If you distribute the funds completely, you have a loss of $6,000. The loss is treated as an itemized deduction varies on Schedule A of Form 1040 (you must list to get any tax benefit from the loss).

At what age can you withdraw from your IRA without paying taxes?

You can withdraw from an IRA at age 59 1/2 without paying penalties. If it’s a traditional IRA, income tax will have to be paid on the amount withdrawn. For a Roth IRA, you’ve already paid taxes, so you won’t have to pay any when you withdraw.

Do you pay tax on IRA withdrawals after age 65?

If you have a traditional IRA, yes, you pay tax on your withdrawals in your regular income tax bracket. If you withdraw from a Roth IRA, you pay no taxes. This is because a traditional IRA is funded with pre-tax dollars and a Roth IRA is funded with after-tax dollars.

Do IRA withdrawals count as Social Security income?

No, IRA withdrawals aren’t considered Social Security income, which means they won’t affect the taxable amount of your Social Security.

The bottom line

There are some good reasons to make IRA contributions non-deductible, but doing so complicates your tax life. Be sure to keep records so you don’t pay taxes on these contributions when you take distributions or make Roth IRA conversions. And if math isn’t your forte, consider getting a tax professional to figure out what you owe.

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