As with many of my articles, I try to pick topics that have come across my desk with the idea that if it applies to one client, there are likely others who could benefit from the knowledge. This month’s article focuses on IRA distribution and how it may or may not be taxable.
To begin w
ith, you may be saying, “I have always paid taxes on my IRA distributions whether they were taken out before age 59 ½ or later.” You may also be thinking that you were sent a form 1099R that reported the distribution to the IRS and to you. You would be correct on both accounts and it is true most IRA distributions are fully taxable in the year they were withdrawn, but as with many areas of our current tax code, there are exceptions to the general rule and that is where my client situation falls.
My client had for many years contributed to his IRA as a part of his overall retirement savings plan. As is the case with many taxpayers, he worked for different employers, some of whom had retirement plans to which their employees could contribute to (a 401(k), for example) and some employers who did not offer a retirement plan to their employees. Whether the employer offered a plan or not is a key item to note as it directly impacts whether or not a taxpayer is allowed to deduct their IRA contributions or not.
The rule for a married couple is that part or all of their traditional IRA may be nondeductible if one of them is covered by an employer-sponsored retirement plan. The ability to get the deduction is then based on various income levels and phase outs. In plain English, the more the taxpayers make, the less likely they will be able to take a deduction for traditional IRA contributions.
For my client story, they had both deductible contributions and non-deductible contributions and they remembered making both, so the challenge is how much of each they had. In 2010, they took a distribution, so this was the year that the record-keeping would pay off. The problem we had is the client wasn’t aware or had not reported the proper information on IRS Form 8606.
Form 8606 is not a common form but it is the one that needs to filed for any year you make a nondeductible contribution to your traditional IRA. So in years where your contribution was fully deductible, there isn’t a requirement to file this form. The other year they were required to file as it relates to my client example is the year that an IRA distribution occurs.
Form 8606 shows the IRS the basis amount of the taxpayer’s IRA. Basis is the term we use to describe the amount of the traditional IRA that is from nondeductible contributions, meaning that those dollar amounts have been previously taxed. The basis of the IRA is the amount of the IRA on which you do not have to pay tax when the IRA is distributed. So if you or your tax preparer have not kept track of those nondeductible contributions in the past, it would be very easy to assume that 100 percent of the IRA distribution would be taxable. If that assumption was made, you are in fact be double taxed on any amount that you were not able to deduct from the original tax year the contribution was made. Nearly everyone agrees double taxation is one thing to avoid and keeping good records of the deductible vs. nondeductible contributions is the key to making that happen.
Some may say, “Hey, why does that matter with the Roth IRA out there?” I agree in most cases it would be better to contribute to a Roth and get the tax-free earnings component in your plan. Remember the Roth hasn’t been around all that long and therefore the choice was not available to many baby boomers until later in their working lives. They may have a traditional IRA that has a percentage that has already been taxed and need to account for that to avoid being hit with a tax bill on the amount a second time.
David Rumsey is the owner of Pettis Rumsey Inc., a Marysville accounting firm that works with small-business owners. For a free report on the top 20 questions a small business should ask before hiring a CPA, go to www.PettisRumseyCPA.com.
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