My client had a IRA that was created with only non deductible contributions. Breaking it down, it was 2/3 contributions and 1/3 earnings. In 2012 without talking to me she rolled a very large 401 (k) into the IRA. Now, the IRA is made up of 1/10 contributions and 9/10 from earnings and the 401k. In 2013 she is going to start taking distributions. To me, what she has inadvertantly done is reduced the amount she can remove tax free every year by making the total value of the IRA greater. She say the people in charge of the IRA say this is not so. What says the forum?
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You are correct. IRA distributions are taxable based on the total value of the IRA at the time of distribution in proportion to the total cost basis (the non-deductible contributions) in the IRA. Adding additional tax-free money to the IRA decreases the proportion that represents non-deductible contributions. You can never fully recover your non-deductible contributions until all of the funds are distributed.
To complicate things further, this rule applies to ALL IRAs. It does not matter that some represent non-deductible IRAs and others represent fully taxable IRAs. All IRAs are combined when calculating the non-taxable portion of any IRA distribution. The only way to avoid this is to keep 401(k) funds in a 401(k) account, meaning you never roll them over into an IRA. TTB, page 13-13 says:
On a NON-tax issue note however, I believe the taxpayer was correct in wanting to roll over her 401(k) into her IRA. Even though this reduces the amount that comes out tax free (because the taxable portion is now greater), she is in control of her IRA. By leaving the money in a 401(k), you are at the mercy of the 401(k) administrator and limited to the types of investments available to that particular 401(k). An IRA allows the taxpayer to be 100% in control of what types of investments the funds are invested in. For example, if your 401(k) can only choose one of John Hancock's mutual funds, that is what you are stuck with. If you prefer to buy a guaranteed annuity with a guaranteed minimum rate of return and a guaranteed retirement payout for life (in effect converting it to a defined benefit type plan), you have to roll it over into an IRA to accomplish that goal. 401(k) accounts generally do not offer those types of investments.Distributions. The tax treatment of a distribution depends upon
the taxpayer’s cost basis in an IRA. If all contributions to all traditional
IRAs were deductible in the past, then a distribution from
any one traditional IRA is fully taxable as ordinary income. If the
taxpayer has a cost basis in any one traditional IRA, a distribution
from any traditional IRA will be partially taxable and partially a
return of the taxpayer’s cost basis. The taxpayer cannot choose
to have the cost basis distributed first. Each distribution must
be partially a tax-free return of cost basis and partially a taxable
distribution. Use Form 8606 to figure the taxable and nontaxable
portion of a distribution.Last edited by Bees Knees; 05-15-2013, 11:07 AM. -
There is one way around this rule, however. If the taxpayer is interested in doing a qualified charitable distribution (QCD), the amount distributed to the charity is treated as first coming from the taxable portion of the IRA, which would result in increasing the cost-basis proportion of the IRA that remains in the IRA after the QCD.
TheTaxBook Planning Strategies book on page 3-9, example #5 and the following author's comment illustrates how this planning strategy works.Comment
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