Most retirement plan
participants use pretax assets to fund their employer-sponsored plans such as
401(k) and 403(b) accounts, or they claim a tax deduction for amounts
contributed to their Traditional IRAs. In both cases, these contributions can
help to reduce the individual’s taxable income for the year to which the
contribution applies. However, it is also possible to contribute amounts to
employer-sponsored plans on an after-tax basis, and for IRAs, contributions can
be non-deductible. The advantage of accumulating after-tax assets in a
retirement account is that when they are distributed, the amounts will be tax-
and penalty-free. However, this benefit is realized only if the necessary steps
are taken.
Keeping
Track of Your After-Tax Assets
Reaping the benefits of this strategy starts with good
record-keeping and clear communication with your plan administrator and the
IRS.
Your
Qualified Plan Account
The administrator for your qualified plan is responsible for
keeping track of which portion of your balance is attributed to after-tax
assets and pretax assets. However, it helps if you check your statements
periodically to ensure that the tabulations match what you think they should
be. This will allow you to clarify possible discrepancies with the plan
administrator.
Your IRA
Your IRA custodian is not required to keep track of the
after-tax balance in your IRA, and most, if not all, do not. As the owner of
the IRA, you are responsible for keeping track of such balances, and this can
be accomplished by filing IRS Form 8606.
If you make a non-deductible contribution to your Traditional
IRA, or roll over after-tax assets from your qualified plan account to your
IRA, you must file IRS Form 8606 for the year the amount is contributed to the
IRA. While the IRS does not currently require Form 8606 to be filed for
rollover of after-tax amounts, it may be a good idea to record such amounts for
your records. Form 8606 lets the IRS know that the amount represents after-tax
assets, and it helps you keep track of the balance of your IRA that should be
tax-free when distributed. Form 8606 must also be filed for any year in which
distributions occur from any of your Traditional, SEP or SIMPLE IRAs and you
have accumulated after-tax amounts in any of these accounts. Make sure you read
the important filing instructions that accompany Form 8606 – they provide
details on the sections of the form that must be completed.
Tax
Treatment of After-Tax Assets
Qualified Plans
Generally, your plan administrator will indicate the taxable
portion of amounts distributed from your qualified plan account on the Form
1099-R that you receive for the year. If the amount is not properly indicated
on the 1099-R, you may want to request written confirmation from the plan
administrator of the portion of the distribution that is attributable to
after-tax assets. This will help to ensure you
include the correct amount in your taxable income for the year.
IRAs
With the exception of ‘return of excess contributions,’ your IRA
custodian is not required to make a distinction between the taxable and
non-taxable portion of amounts distributed from your Traditional IRA. You must
provide that information on your income tax return by indicating the entire
amount of the distribution versus the amount that is taxable. For more
information, see the instructions for line 15a of IRS Form 1040. The
aforementioned Form 8606 will help you determine the taxable and non-taxable
portions of amounts distributed from your Traditional IRA.
Pro-Rata Treatment of Distributions
If your qualified plan or 403(b) account or Traditional IRA
includes after-tax amounts, distributions usually include a pro-rata amount of
your pretax and after-tax balance. For this purpose, all of your Traditional,
SEP and SIMPLE IRAs are treated as one account. For instance, assume that you
made an average of $20,000 in after-tax contributions to your Traditional IRA
over the years and your Traditional IRA also includes pretax assets of
$180,000, attributed to rollover of pretax assets and deductible contributions.
Distributions from your IRA will include a pro-rata amount of pretax and
after-tax assets. Let’s look at an example using these numbers.
Example
John has several IRAs, which consist of the following balances:
§
Traditional IRA No. 1, which includes his non-deductible
(after-tax) contributions of $20,000
§
Traditional IRA No. 2, which includes a rollover from his 401(k)
plan in the amount of $150,000
§
Traditional IRA No. 3, which is really a SEP IRA, which includes
SEP contributions of $30,000
Total $200,000
In 2013, John withdraws $20,000 from IRA No. 1. John must
include $18,000 as taxable income from the $20,000 he withdrew. This is because
all of John’s Traditional, SEP and SIMPLE IRAs are treated as one IRA for the
purposes of determining the tax treatment of distributions, when John has basis
(after-tax assets) in any of his Traditional, SEP or SIMPLE IRAs.
The following formula can be used to determine the amount of a
distribution that will be treated as non-taxable:
Basis / Account Balance x Distribution Amount = Amount Not
Subject To Tax
Using the figures in the example above, the formula would work
as follows:
$20,000 / $200,000 x $20,000 = $2,000
Since IRS Form 8606 includes a built-in formula to determine the
taxable amount of distributions from your Traditional IRAs, you may not need to
use this formula for distributions from your IRA.
For qualified plan accounts that include a balance of after-tax
amounts, distributions are usually pro-rated to include amounts from pretax and
after-tax balance. This means that, similar to IRAs, you can’t choose to
distribute only your after-tax balance. However, certain exceptions apply. For
instance, if your account includes after-tax balances accrued before 1986,
these amounts may be distributed in full, resulting in the entire amounts being
non-taxable, rather than being pro-rated.
Rollover
of After-Tax
Balance
If your retirement account balance includes after-tax amounts,
whether these amounts can be rolled over depends on the type of plan to which
the rollover is being made.
The following is a summary of the rollover rules for these
amounts:
§
IRA to IRA:
All rollover eligible amounts can be rolled over to an IRA. This includes
after-tax amounts.
§
IRA to Qualified Plan/403(b):
All rollover eligible amounts can be rolled over to a qualified plan/403(b),
provided the plan allows it. However, this does not include after-tax amounts –
such amounts cannot be rolled from an IRA to a qualified plan/403(b).
§
Qualified Plan/403(b) to
Traditional IRA: All rollover eligible amounts can be rolled over to a
Traditional IRA. This includes after-tax amounts.
§
Qualified Plan/403(b) to
Qualified Plan/403(b): All rollover eligible amounts
can be rolled over to another qualified plan/403(b), provided the plan allows
it. This includes after-tax amounts, provided these amounts are transacted as
direct rollovers.
The
Bottom Line
Bear in mind, this is just an overview of the rules that apply
to your after-tax balance in your retirement account. Having a thorough
understanding of the rules will ensure that you include the right amount in
your taxable income for the year you receive a distribution from your
retirement account, thereby not paying taxes on amounts that should be
tax-free. As always, be sure to consult your tax professional for assistance to
make sure that your after-tax assets are treated correctly on your tax return,
and so that you know what tax forms to file each year.
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