NONDEDUCTIBLE IRAs CAN CREATE CONFUSION
-If you have nondeductible IRAs, the form you must prepare is not worded in a way that is easy to interpret. If you have made both deductible and nondeductible contributions to traditional IRAs, then part of your withdrawals are attributable to the nondeductible IRAs and can be withdrawn without paying tax again. But to make it complicated, you have to calculate the percent that can be withdrawn tax-free using Form 8606.. All withdrawals have to be allocated between taxable and nontaxable every year in which you make a withdrawal. You must also update your basis every year in which you make a contribution.
You must update your nondeductible IRA basis, using Form 8606, whether you made withdrawals or not.
NOTE: The allocation applies only to traditional IRAs, not Roth IRAs which do not enter into this calculation. Traditional IRAs are any IRA other than a Roth IRA.
The first line of Form 8606 seems self-explanatory. It asks for nondeductible contributions for the tax year, including those made through April 15 of the year after the tax year.
Line 2 is somewhat confusing.
It asks for your basis in traditional IRAs. The key word is basis. You only have a basis if you paid for it with after-tax money. If you deferred the tax by deducting an IRA contribution, your basis is zero.
So, ENTER just the value of your nondeductible IRAs on line 2
Line 6 asks for the value not basis of your traditional IRAs. The value is both the basis of your nondeductible IRAs plus the value of your deductible IRAs. This amount is the value of your IRAs as of December 31 of the tax year for which you are reporting.
Line 7 asks for distributions you received during the tax year. This amount is added back to the year-end value to get the total you would have had if there had been no withdrawals.
Line 8 asks for anything you converted to a Roth IRA. This is also to be added back to the year-end value since a conversion would be equivalent to a withdrawal.
Line 9 is the Total of Lines 6+7+8.
Line 10 is line 5 (nondeductible IRA basis) divided by line 9 (total value at year-end plus withdrawals and conversions) divided.
The rest of the form is used to calculate the taxable and nontaxable portion of your IRA withdrawals for the year and to calculate the remaining basis of your nondeductible IRAs which will become Line 2 on next year’s Form 8606.
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This information is not intended to be advice to the recipient. In compliance with Treasury Department Circular 230, unless stated to the contrary, any Federal Tax advice contained in this Blog was not intended or written to be used and cannot be used for the purposes of avoiding penalties.
6 comments:
I am still confused. You wrote "So, ENTER just the value of your nondeductible IRAs on line 2." That is easier said than done. What if your IRA value came from different sources? Money paid in with after-tax dollars, plus money rolled over from a 401k at a former job, plus reinvested dividends from each? Is the "value of your nondeductible IRAs" the total of all previous contributions or are reinvested dividends from those investments thrown in while perhaps dividends from the 401k not?
If reinvested dividends were reinvested within the non-deductible IRA they would not be taxed.
If you received a dividend, then invested the proceeds in a non-deductible IRA they would have been taxed when received. Once money goes into an non-deductible IRA the source of the funds invested is not relevant, only the amount invested which would determine the basis of the non-deductible IRA.
The basis is relevant when withdrawals are made and you have both deductible and non-deductible IRAs, since the basis of the non-deductible amount is used to determine the percent that is not taxed when withdrawn.
If money came from a 401K plan or anything going into a rollover IRA you only have untaxed money going into that IRA. Any money you put into anything other than a rollover IRA would either go into a deductible or non-deductible IRA depending on your choice subject to being an allowable choice.
Thanks for the fast response. Please forgive my lack of understanding. Let's suppose someone changes their first job and rolls over a 401k with a value of $2000 into a traditional IRA. In that IRA he applies that $2000 to buying an index fund. A year later that has produced $20 in dividends, which are reinvested in the fund (without a distribution). The next few years he adds another $5000 to the IRA using post-tax money as non-deductible contributions, also invested into the index fund. Another year goes by and there are $70 in dividends generated from the fund (about $20 more from the initial investment and $50 from newer one) and these are reinvested as well. If I understand correctly, the basis stays at $5000, with the total value of the IRA now at $7090. And not a new basis of $5050, since $50 of the dividends were produced by the post-tax contribution. Is it correct to say that this isn't a "non-deductible IRA" but rather that the IRA account's value is made up of amounts from both pre-tax (401K) and post-tax (non-deductible) contributions? Both are invested in a single mutual fund within a single IRA account. Or should the rollover IRA account been set aside and a separate IRA created for separate contribution sources?
I think you must be assuming the rollover IRA and the non-deductible IRA can be one, single account.
You cannot commingle deductible and non-deductible IRAs. If you want the rollover to remain a rollover, you must leave it as a rollover. However, you can move it into a non-rollover--but it should still be in a deductible IRA and cannot be part of a non-deductible IRA.
You can invest all funds in the same Index fund, but in two separate accounts.
Yes, one single account has been my assumption for a number of years. I started an IRA account from a rollover many years ago at Vanguard and since then over the years have been adding post-tax non-deductible contributions. I think keeping these separate would have made things simpler, but no one at Vanguard ever indicated that it was not allowed or even recommended practice. I called them today and they said again that it was fine, but I would be welcome to open a separate one if I'd like. At this point the rollover and the non-deductible contributions are co-mingled. Is there an IRS rule somewhere stating they should be separate? If there is such a rule or law, I'm surprised Vanguard allowed contributions to go into the account after the rollover.
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