Matter & Substance
  January 3, 2019

Don’t get taxed twice on nondeductible IRA contributions

Do you make nondeductible contributions to a traditional IRA? If so, it is important to understand the tax treatment of distributions to ensure you're not taxed twice on the same income.

Justify your strategy

There are several reasons you might make nondeductible contributions to an IRA:

  • You or your spouse has an employer sponsored retirement plan and your income exceeds the threshold, reducing or eliminating your deductible IRA contributions
  • Your income is too high to qualify for a Roth IRA contribution
  • You wish to take advantage of tax-free growth by making the maximum contribution (currently, $5,500/year, $6,500/year if you're over 50)

But for this strategy to make sense, you need to ensure that you're not paying tax on IRA distributions of nondeductible (and, therefore, previously taxed) contributions. This will require you to calculate the portion of each distribution attributable to deductible and nondeductible contributions and file Form 8606 with your federal income tax return.

Do the math

Consider the following example: Nick has $500,000 in his traditional IRA account as of November 1, 2018. Of that balance, $125,000 is attributable to deductible contributions, $200,000 to nondeductible contributions, and $175,000 to investment earnings within the IRA. Nick takes a $50,000 distribution from the IRA and reports the entire amount as taxable income on his 2018 return. By doing so, he pays tax a second time on the portion of the distribution attributable to nondeductible contributions, which were already taxed in the years he made those contributions.

To avoid double taxation, Nick must determine the portion of his distribution that's attributable to nondeductible contributions. Suppose the IRA's balance is $475,000 on December 31, 2018 - $500,000 less the $50,000 distribution plus additional earnings after November 1. To determine the nontaxable portion of the distribution, Nick adds the $50,000 distribution to his IRA's year-end balance (for a total of $525,000) and divides nondeductible contributions ($200,000) by that amount. He multiples the resulting percentage - 38% - by the $50,000 distribution to determine the nontaxable portion ($19,000). Because $19,000 of Nick's distribution has come from nondeductible contributions, those are reduced by $19,000 (to $181,000) for purposes of future distributions. 

Handle with care

A word of caution: You can't avoid taxes altogether by making nondeductible contributions to a separate account and then taking distributions from that account. For tax purposes, the IRS treats all traditional IRAs as a single IRA, meaning no matter which account they come from, your distributions will consist of a combination of taxable and nontaxable funds. Give us a call, and we can help you structure this properly.