Detailing the Pro-Rata Rule

For IRA distribution purposes, all IRAs (except Roth IRAs) are considered one big giant IRA. It doesn’t matter if you have one IRA that was rolled over from a former employer, and one SEP IRA with your current employer, and one contributory IRA where you put annual contributions, and one after-tax IRA where you put contributions for which you do not take a deduction. All four IRAs will be considered one IRA any time you take a distribution.

Since they are all one IRA for distribution purposes, you cannot separate out any one component of your IRAs. You cannot take out or convert only the after-tax funds in your IRA. All distributions or conversions will be treated pro-rata.

You track your after-tax IRA funds on IRS Form 8606. The form must be filed with your tax return in any year that you make an after-tax contribution (or rollover after-tax funds from an employer plan to your IRA), and it must be filed in any following year when you take a distribution from your IRA. The form will calculate the amount of your distribution that is taxable.

Put simply, the form takes the total year-end balance of all your IRAs and divides that into the total balance of all after-tax amounts in all IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the distribution. The remaining balance of the distribution is taxable. The tax-free amount of the distribution will reduce the total after-tax amount carried forward to your next Form 8606.

Example: John has a rollover IRA from a previous employer of $270,000 and an “after-tax” IRA account with $30,000 of total contributions in it. John takes a distribution of $30,000 from his after-tax account and converts it to a Roth IRA. His total account balance is $300,000 ($270,000 + $30,000 = $300,000). 10% of his distribution will be tax free ($30,000 / $300,000 = 10%). He will pay income tax on $27,000 ($30,000 X 10% = $3,000 tax free, balance $30,000 - $3,000 = $27,000 taxable). Even though he has closed his after-tax IRA, his rollover IRA balance will now include the remaining after-tax balance of $27,000 ($30,000 after-tax balance - $3,000 distributed = $27,000).

As you can see from the calculation, it won’t matter what IRA account you take the distribution from. Some of the distribution will be taxable and some will be tax-free. The overall totals of your pre-tax and after-tax amounts will be reduced without regard to the account the funds came from.

This is another installment in our weekly look at The Slott Report's "Best of 2013". New articles return next week!

-By Beverly DeVeny and Jared Trexler

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Non-Deductible IRA Contributions: What You Need to Know

In order to make an IRA contribution, you must be younger than age 70 1/2 for the year and also have wages or compensation from your job. Once you make your IRA contribution, then you have to figure out whether it's tax deductible or not.

If either you or your spouse actively participates in an employer retirement plan at work, then you might not be able to take a tax deduction, depending on your income. If you, or your CPA, determine that you aren’t eligible to take a tax deduction for your IRA contribution, then your IRA contribution is nondeductible.

If you make an IRA contribution that isn’t tax deductible, you must file IRS Form 8606 to report it as nondeductible. You will now have what’s known as “basis” in your IRA (money that isn’t taxable when you later take a withdrawal). Even though you may not get a tax deduction, nondeductible IRA contributions will give you tax-deferred interest just like all of your other IRA money; plus, you are saving more money for your retirement.

When you have basis, you’ll also have to file Form 8606 in any year you take a distribution from any traditional IRA, including SEP and SIMPLE IRAs, to calculate the nontaxable portion of your withdrawal.

If you don’t file Form 8606 to report nondeductible contributions, then there’s a $50 IRS penalty. But worse than that, if you can’t prove you have basis, all of your future IRA distributions will be treated as fully taxable.

Roth IRA contributions are also not tax deductible, but you don’t file Form 8606 to report Roth contributions. If you discover that your IRA contribution isn’t tax deductible, you are better off making a Roth IRA contribution instead. Assuming your income isn’t too high, the Roth IRA funds grow tax-free, not just tax-deferred. The income limits for making a Roth IRA contribution for 2013 are $178,000- $188,000 if you’re married filing jointly or $112,000 - $127,000 if you’re single.

For example, if you’re married filing joint and you and your spouses’ total income is below $178,000, you can make a full Roth IRA contribution of $5,500 (or $6,500 if you’re age 50 or older).

-By Joe Cicchinelli and Jared Trexler

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Slott Report Mailbag: Can I Convert My Non-Deductible IRA Contributions to a Roth IRA?

This week's Slott Report Mailbag discusses Roth IRA contributions, conversions and the availability of certain employer-sponsored retirement plans.  As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

For the last 15 years, I have been putting money in my traditional IRA. I have also been maxing out on my pension at work. Since I never took a deduction for my IRAs, I would like to transfer my traditional IRA to a Roth IRA. What difficulties will I have with the IRS?

John Di Paolo

Answer:

Send questions to [email protected]

You should have no problem converting your non-deductible IRA contributions to a Roth IRA as long as you have been filing IRS Form 8606 with your tax return in each year that you made a non-deductible contribution. The conversion of IRA funds to a Roth IRA is taxable. Because you have non-deductible contributions, those amounts aren’t taxed when they are converted but the earnings will be. There is a pro-rata rule that will apply at the time of your conversion. It can be found on Form 8606. All of your IRA accounts are looked at as one account and will be part of the pro-rata calculation. Your conversion to a Roth IRA will be partly taxable and partly after-tax based on the ratio of all of your after-tax amounts divided by the total balances in all your IRA accounts.

2.

Hello,

Can I contribute to my company 401(k), Health Savings Account (HSA), and a Roth IRA in the same tax year? If so, what are the income and contribution limits?

My wife and I are both in out middle 50s and have an AGI (adjusted gross income) of about $100,000 annually. For 2013: 8% of my paycheck is withheld for our company 401(k) (maximum % the company will match funds). I have $6,500 that will be funding a HSA and would also like to contribute to a Roth IRA (if tax code permits).

Michael in Mount Vernon

Answer:
There are no income limits to contribute to a 401(k), however, the income limits for contributing to a Roth IRA for 2013 are $178,000 - $188,000 if you file jointly. The tax code allows you to contribute to all three if you meet the requirements for all of them.

3.

If a company already has a SEP IRA, can they contribute to an IRA for certain employees as well?

Best regards,

Stacey

Answer:
Yes. An employer-sponsored IRA arrangement allows an employer to contribute to IRAs of any employees he or she chooses. The IRA contribution is treated as wages to the employees.

-By Joe Cicchinelli and Jared Trexler

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Reminder From IRS: Don't Forget Your 2010 Roth Conversion!

IRS recently issued a "friendly" reminder to taxpayers who did Roth conversions back in 2010 and took advantage of the two-year deal to split their conversion income equally between 2011 and 2012.

IRS wants to be sure that those taxpayers do not "forget" to include the second half of their conversion on their 2012 tax returns.

Normally, a conversion is taxable in the year the funds left the IRA or employer plan (you do not have until April 15th to do a conversion for the prior year like you do for a Roth contribution). In 2010, Congress needed to raise money so it encouraged us to do Roth conversions by allowing us to not include the income on our 2010 tax returns, but to instead include half of the converted amount on our 2011 return and the other half on our 2012 return. Now, it is time to pay the piper.

Don’t think that IRS has forgotten about your tax bill. In 2010, they made you tell them how much you needed to include on your 2012 return. It was done on IRS Form 8606 in Part II for an IRA conversion and Part III for a conversion from a plan. Since the ability to defer the income for two years was only available in 2010, you will only find that specific language on the 2010 version of Form 8606.

If you do not have the funds to pay the tax, you do not have too many options. It is too late to recharacterize the Roth conversion and get out from under the tax bill. A 2010 Roth conversion could be recharacterized up to October 15, 2011. IRS has the ability to allow a taxpayer additional time to do a recharacterization, but generally will only do so if the failure to do a recharacterization is due to advisor error. The extension of time can only be granted through a private letter ruling request and IRS charges a fee of $4,000 for those requests. You will have to pay professional fees for someone to prepare that ruling too. There is no guarantee that a taxpayer’s request will be granted.

So, make sure you include the last installment of income from those 2010 Roth conversions on your 2012 tax return. If you cannot pay the tax bill, seek the advice of a tax professional for your options on dealing with IRS.

Article Highlights:

• The last installment of income from a 2010 Roth conversion is due with 2012 income tax returns
• There is no ability to recharacterize a 2010 Roth conversion

- By Beverly DeVeny and Jared Trexler

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Don't Forget About Your 2010 Roth Conversion on Your 2012 Tax Return

As we gather our information to prepare our federal income tax return for 2012, don't forget about that Roth IRA conversion you did all of the way back in 2010. A conversion you did from a company plan or IRA to a Roth IRA in 2010 will likely need to be reported on your 2010 tax return.

Before 2010, there were restrictions on who could convert IRA money to a Roth IRA. For example, if you were single or married filing jointly, your modified adjusted gross income (MAGI) had to be less than $100,000 for the year to be eligible to do a conversion. If you were married filing separately, you could not do a Roth IRA conversion, even if your MAGI was less than $100,000.

Starting for 2010, the Tax Increase Prevention and Reconciliation Act (TIPRA) eliminated the $100,000 income limit, allowing you to convert your IRA to a Roth IRA, no matter how much your MAGI was for the year. Also, if you are married filing separately, you are now eligible for a conversion. Basically, every IRA owner could convert to a Roth IRA starting in 2010.

What is the general rule? When you convert IRA or company plan money to a Roth IRA, the conversion is taxed for the year the money was distributed from the retirement plan. But there was a special 2-year tax break for conversions done in 2010. Unless you chose to have the entire conversion amount taxed in 2010, none of the income from the conversion was taxed in 2010; instead, half of the income was taxed in 2011 and the other half in 2012.

If you did a Roth IRA conversion in 2010 and took advantage of the 2-year special tax break, remember that the remaining half of that 2010 conversion amount is taxable for 2012. To figure what’s taxable for 2012, simply go to your 2010 copy of IRS Form 8606, and look at the amount in line 20b, Amount subject to tax in 2012. This is the amount of income that needs to be added to your 2012 federal income tax return (IRS Form 1040).

If you took a distribution of any 2010 conversion funds in either 2010 or 2011, the amount to be included in income for 2012 should be reduced. The reduction would be calculated on Form 8606 in the Distributions from Roth IRAs section of the form.

Article Highlights
• If you did a Roth IRA conversion in 2010 and used the special 2-year tax rule, half of that income is taxable for 2012
• Your 2010 IRS Form 8606 will tell you what amount remains to be taxed for 2012.

-By Joe Cicchinelli and Jared Trexler

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There is No Such Thing as a Non-Deductible IRA

I hear this a lot. "The contribution is to a non-deductible IRA." Or, "I have a non-deductible IRA." There is no such thing as a non-deductible IRA. There are non-deductible contributions made to an IRA.

Think about it. Even if a contribution is made to a non-deductible IRA, it will not remain entirely non-deductible for long. There are some sort of earnings on the account - even if it is invested in a money market IRA. Would you make a contribution to an IRA that guaranteed no earnings for as long as you had any funds in the account?

Here are some other reasons why there is no such thing as a non-deductible IRA.

• The IRA custodian is not responsible for tracking your non-deductible dollars in an IRA. You do that by filing Form 8606 with your tax return.
• For tax purposes, all IRAs (except for Roth IRAs) are considered one IRA and your distributions are taxed pro-rata - partly from your deductible (pre-tax) IRA funds and partly from your non-deductible (after-tax) IRA funds.

Once you have both deductible and non-deductible amounts in any IRA that you own, including SEP and SIMPLE IRAs, you generally can never take out only the non-deductible amounts. We call this the cream in the coffee rule. Once you put cream in the coffee, all coffee removed from the cup is partly cream and partly coffee.

The taxability of any distribution from any IRA once you have made a non-deductible contribution is calculated on that same Form 8606. An IRA owner must file this form in any year that they make a non-deductible contribution and in any year that they take any distribution from any IRA after they have non-deductible funds in any IRA.

Article Highlights

• There is no such thing as a non-deductible IRA
• When there is after-tax money (basis) in any IRA, the pro-rata rule applies to all IRA distributions
• After-tax funds are tracked on IRS Form 8606, which the taxpayer files with their tax return 

- By Beverly DeVeny and Jared Trexler

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2011 IRA Contribution: It's Not Too Late to Change Your Mind

Even though the 2011 tax season for most of us ended on April 17, 2012, some of us who made a timely IRA contribution for 2011 might have changed our mind on that IRA contribution. Specifically, some individuals who contributed to one type of IRA for last year may now want to change that contribution into a different type of IRA contribution.

A “recharacterization” allows individuals, after-the-fact, to change their IRA contribution into a different type of IRA contribution if certain rules are met. The 2011 IRA contribution deadline was April 17, 2012, so anyone who didn’t make a contribution by that time cannot do so now. However, those who did can change their mind by recharacterizing.

To recharacterize a 2011 contribution, you must have the original contribution (plus interest) transferred directly to the second IRA of a different type (e.g., Traditional IRA to Roth IRA). If this is done by October 15, 2012, you treat the 2011 IRA contribution as having been originally made to the second IRA.

The most common recharacterization occurs after someone converts funds from a Traditional IRA to a Roth IRA. Afterwards, that individual may want to undo the conversion, usually because they don’t have the money to pay the taxes on the conversion or because the investments in the Roth IRA declined significantly. That person could simply recharacterize the Roth conversion plus its net income (or loss) back to a Traditional IRA. The tax debt on the conversion is erased as if the funds were never converted to a Roth IRA.

Recharacterizations are not taxable but they must be reported to the IRS, so anyone who filed their 2011 tax return by April 17, 2012 and then properly recharacterizes a 2011 contribution or conversion by October 15, 2012 would have to file an amended tax return to report the recharacterization. Even if you do the recharacterization before you file your return, you must report the recharacterization on your return so that IRS can properly match up the tax reporting for all transactions. We have seen a number of individuals who missed this step and got letters from IRS looking for taxes that were no longer owed due to a recharacterization. The instructions for reporting a recharacterization can be found in the instructions for IRS Form 8606.

IRS Publication 590, Individual Retirement Arrangements is a good source of information on recharacterizations. Both the IRS Publication 590 and Form 8606 are available on the IRS website www.irs.gov.

-By Joe Cicchinelli and Jared Trexler

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Where Do After-Tax IRA Contributions Go On Your Tax Return?

You made after tax-contributions to your IRA. How does IRS know that you have after-tax money in your IRA?

You must file IRS Form 8606 with your tax return. This form will track your after-tax IRA contributions. Each year you bring the prior year-end balance forward and add any new after-tax contributions to the total.

Once you have after-tax amounts in your IRA you generally cannot take a distribution of just the after-tax amounts from your IRA. You must pro rate all distributions. This formula is also on Form 8606. For this rule, all IRAs are considered one IRA (including SEP and SIMPLE IRAs) and all distributions are treated as one distribution. You take the balance of all your after-tax contributions and divide it by the total of all the balances in all your IRAs. The percentage you get is the percent of your distributions for the year that are income tax free. You then subtract the after-tax amount distributed for the year from your total after-tax balance to come up with your new beginning balance for the next year.

Make sure you file this form with your return. Otherwise, you may end up paying income tax again on your after-tax contributions.

-By Beverly DeVeny and Jared Trexler

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