Increasingly, individuals bear more of the responsibility for accumulating the resources needed for consumption in retirement. As employer-sponsored defined benefit plans decline in popularity, a greater emphasis is placed on employees to save at levels that are sufficient enough to maintain an optimal lifestyle in retirement.
To ensure a comfortable retirement, individuals may need to contribute sums over and above the contribution limits stated for their employer-sponsored defined contribution plans. When considering the ideal location for these additional retirement savings, people sensibly choose to take advantage of all the tax-sheltered accounts available before saving and investing assets in taxable accounts. Even though it does not allow a current year income tax deduction, a nondeductible IRA contribution proves valuable because the contributed funds benefit from growth without the friction of an annual tax drag. Over time, the benefit of tax-deferred compounding growth becomes a dominant force for accumulating a respectable retirement nest egg.
Given this confluence of events, tax practitioners need to be diligent and ascertain whether clients are making any nondeductible IRA contributions for two reasons. First, it’s always important to remind clients to give some thought surrounding their retirement plan. Second, it’s imperative to make sure any nondeductible IRA contributions are tracked and reported.
Often, clients assume that since a nondeductible IRA contribution does not affect their taxes at the time of contribution, they do not need to report or mention it. However, tax practitioners understand that this view is faulty. In an employer-sponsored qualified retirement plan, the plan administrator or custodian is responsible for keeping track of pre- and after-tax amounts. However, that is not the case with an IRA; the responsibility for tracking the tax basis falls exclusively on the account owner. Failing to keep good records may result in double taxation when the funds are ultimately withdrawn.
The commonly overlooked IRS Form 8606, Nondeductible IRAs, is filed with the individual’s tax return and functions to track after-tax contributions made to traditional IRAs. Nondeductible IRA contributions need to be reported each year on Part I of Form 8606. Tax practitioners should advise clients that filing this form will save additional tax dollars and reduce complexities when funds are eventually distributed from the IRA account during retirement.
The taxation of an IRA distribution depends on whether the original contributions to the IRA account were made with pre- or after-tax dollars. When nondeductible contributions are made, a tax basis is created in the account since the dollars contributed have already been taxed. Once an IRA contains after-tax funds, a portion of any withdrawal is excluded from taxable income. For this important calculation to be accurate, the taxpayer needs to exercise diligence in reporting and tracking nondeductible contributions on Form 8606.
The nontaxable portion of an IRA distribution is determined by the “pro-rata” rule. The calculation, computed on Form 8606, compares the cumulative nondeductible contributions to the balance of all IRA accounts in an individual’s name. For example, let’s say a client made $50,000 of nondeductible contributions to an IRA that has a current value of $100,000. Assume this individual also has a second IRA with only pre-tax contributions and a current market value of $25,000. If the individual takes a $10,000 distribution, 40 percent of that distribution represents a recovery of basis ($50,000/$125,000 = 40 percent) and is excluded from taxable income. Therefore, the $10,000 withdrawal will result in just $6,000 of taxable income because $4,000 ($10,000 X 40 percent) is excluded.
As a tax practitioner serving clients in the retirement accumulation phase of the lifecycle, it is crucial to inquire about any nondeductible IRA contributions. Since retirement distributions may not occur until decades into the future, it is quite easy to lose track of the after-tax amounts. Be sure to help your clients keep immaculate records! The account beneficiaries will also be able to exclude the basis portion of taxable income upon inheritance. A little diligence, while ensuring the proper forms are filed and retained, will save your clients from overpaying their tax liability on distributions in retirement.