Distribution on Non-Deductible TIRA to avoid double tax?
I’ve been mulling Roth conversions for two IRAs.
One is a SEP IRA, larger and funded with pre-tax contributions. I need to come up with cash to convert (or partially convert) but at least I’m only going to be taxed once.
The other is a smaller Traditional IRA. This one was funded entirely with non-deductible contributions. I already paid tax on what I put into it and I’m reluctant to pay double tax to convert it. Given the double-taxation of the non-deductible contributions, I think this IRA was a mistake from the start. I’m also pretty sure I’m underwater in it without a gain.
I came up with a possible solution: What if I take a distribution from this IRA for the entire amount? Unlike a conversion, my basis should be taken into account. I’d need to pay tax only on the gain, which should be zero. I’d need to pay the penalty of 10%, but I think that would be the only haircut needed.
What do you think?
Thanks,
Mark
Permalink Submitted by mk foss on Mon, 2010-12-20 22:58
All of your IRAs are treated as one for purposes of taking distributions or converting to Roth. Form 8606 is used for the calculations.
If you converted the IRA with the nondeductible contributions, you would pay tax on a portion of the SEP.
If you cashed out the IRA with the nondeductible contributions, you would pay tax on part of the SEP – you can’t just pay tax on the growth in that particular IRA.
If you wanted to cash out the IRA and recognize a loss (if contributions are greater than the current market value) it wouldn’t work – you can only take a loss on cashing out an IRA if ALL IRAs are liquidated including SEPs and Simples.
Permalink Submitted by Alan Spross on Mon, 2010-12-20 23:06
Since all your IRAs are considered as one combined account for income tax purposes, your plan would not work.
When you made your non deductible IRA contributions you should have filed Form 8606 each year reporting them as non deductible. This is how you prevent double taxation of the funds. If you did not file the form, with some research you can still file them retroactively starting with the oldest year and the IRS will let you do that without penalty.
When you distribute funds from your IRAs OR convert them, Form 8606 is also used to report the distribution or conversion and the pro rate factor to determine the taxable amount is generated from this form. Since you have the larger SEP IRA, your combined IRA is not likely to be underwater. Let’s assume your cumulative basis from non deductible contributions is 20% of your total value at the end of the conversion year. In that case you would be taxed on 80% of your conversion regardless which IRA you used as the source for your conversion.
If you filed the 8606 forms, this is fairly simple. If not, then the records you did retain, the tax returns that you did retain and tax accountants that did your return might all have to be consulted to reconstruct your contributions over the years and determine what year you needed to file the retroactive 8606 for. This could go back as far as 1987, the first year that contributions might not be deductible. This is really where the work is. Only you and the IRS know if you deducted a contribution or not, the IRA custodian does not.
Also, there is no 10% penalty on Roth conversions, just the income tax. Note that since there is likely no time to research the amount of your non deductible contributions if you do not have the records, you can still convert in the next 10 days for a 2010 conversion which allows you to split the income over two years. If you then determine that the taxable % is too much, you have until next October to recharacterize (reverse) all or part of the conversion to eliminate or reduce your tax bill.
Permalink Submitted by Mark Durrant on Tue, 2010-12-21 00:00
Thanks for the help gents. This was very helpful!