Non-Deductible IRA Question

Submitted by John Boyle on Sat, 2020-12-05 18:30

Husband and wife (both over 59.5) have several Traditional IRAs, mostly pre-tax, but some with after-tax contributions. I understand the pro-rata rule for converting to Roth and/or distribution. here is my question: the wife dies. Can the husband take a distribution of one of his wife’s non-deductible IRAs and only pay the tax on the gain, or is there still a pro-rata issue? The husband does have the 8606 forms from the years of contributions.
Thanks



Submitted by Alan - IRA critic on Sat, 2020-12-05 19:01

  • Both spouses have basis in their IRA accounts, but one spouse likely has a higher % of basis. If his wife has a higher basis % than he does, he can leave her IRA titled in beneficiary form, take the distribution he needs from the inherited IRA, and report the distribution on an 8606 for the inherited IRA only, and pay less in taxes.
  • If his basis % is higher, then he should take the distribution from his IRA for the same reason.
  • If the basis % are about equal, he can avoid maintaining separate IRAs with their own basis and assume ownership of the inherited IRA. Once done, the basis amounts are combined on a single 8606 and the distribution he needs will be pro rated under the combined basis amount. If the 8606 forms are current it should be a simple matter to determine whose IRA has the higher basis %.
  • He could also take take a distribution from the inherited IRA if it has a higher basis %, and after the distribution is done could then assume ownership of it. In that case, the inherited IRA 8606 reporting the distribution will use the DOD value on line 6 instead of the year end value to calculate the taxable portion. The 1099R will be coded 4 (death distribution).  So the central question is whether their basis %s differ enough to warrant keeping the inherited IRA separate or whether the simpler route of combining them is preferable. 
  • To be clear, their basis amounts are not combined until he assumes ownership of the inherited IRA. Until that happens any distributions from his IRA will need an 8606 for him, and any distributions from the inherited IRA will need a separate 8606 indicating “Inherited IRA” at the top.

Submitted by John Boyle on Sat, 2020-12-05 23:05

We are trying to unwind the non-deductible IRAs, by hopefully avoiding the pro-rata rule. Just so I understand, If he assumes his wife’s pre-tax IRAs as his own, and moves his wife’s non-deductible IRAs to an inherited IRA, can he distribute the full inherited IRA and only pay tax on the taxable portion? Does the pro-rata rule come into play anywhere?

Submitted by Alan - IRA critic on Sat, 2020-12-05 23:57

  • The only way it is possible to free up the IRA basis and avoid pro rating, so it can be converted or distributed tax free is to roll the pre tax amount into an accepting employer plan, which would in most cases have to be his current employer. Otherwise, distributions will always be pro rated. The only option then is to take the distribution from the inherited IRA if it has a higher basis %, or from his own IRA if his basis is a higher %.  If he elects ownership, then all the basis of both is combined as are the IRA balances. Typically, basis is a small portion of the total balance, usually less than 10%, so even if the distribution is made from the IRA with the highest basis %, it is likely that 90% + of that distribution will be taxable. 
  • Why is he set on taking the distribution from the inherited IRA? Does he know that her basis % was higher than he has in his own IRA?  If the inherited IRA is worth 100k, and she had 10k of basis, any distribution he took from the inherited IRA would be 90% taxable, regardless of whether is distributed the entire account of just a portion. Pro rating does not mean that there will be double taxation, it just means that one cannot  separate the basis from the pre tax amounts (unless the pre tax amounts can be rolled into an employer plan). He could not roll an inherited IRA into an employer plan anyway, he could only roll his own IRA pre tax amount into his employer plan, or if he elects ownership of the inherited IRA, he could then roll the total pre tax amounts of both IRAs into his employer plan. Whatever total basis was left behind in the IRAs could then be distributed tax free. This is the only way to separate the pre tax amounts from the basis to free up the basis. 
  • Therefore, I would approach this goal in the following order. First, determine if he has an employer plan that will accept IRA rollovers, and if he even wants to roll any of these IRAs into that plan. If not, then determine which spouse’s IRA has the highest basis %, and take the distribution from that account (either the inherited IRA or his own IRA).  Most of that distribution will be taxable, but a smaller portion will be taxable if he uses the account with the highest basis %. 
  • With respect to the inherited IRA mechanics, he must present a death cert and his beneficiary contact information such as name, address and SSN. The custodian then retitles the account as an inherited IRA with him as beneficiary. At this point her basis is still locked into that inherited account, and if it is a lower % than the basis in his IRA, he should take the distribution from the inherited account and the tax would be lower than if he took a distribution from his IRA. I could be more specific if you knew the basis % of each. To get that you need the current value of each IRA, and the basis amount from the last 8606 filed. Then divide the basis figure on line 14 of the last 8606 by the  current value of that IRA only and that is the basis %.  If he owns more than one IRA account or he inherited more than one, then the total value of each’s accounts must be used. 

Submitted by John Boyle on Sun, 2020-12-06 20:24

Thanks for helping me with this, Alan. To be clearer: the husband is over 59.5 and is still working. He has $500k (all pretax) in an IRA. He and his wife (recently deceased) each have $30k (each with $29k non-deductible basis) in IRAs. Without moving all IRAs to 401k, I’m trying to see if there’s a way for him to at least segregate his wife’s IRAs in inherited IRAs, to see if he then closed the inherited IRAs, would he only pay tax on the $1k gain, or is he still stuck with the pro rata rule. I’m not a CPA, so I don’t do his taxes, but I feel he’ll wind up paying tax twice on this money if the non-deductible money isn’t addressed. He has the 8606s for the years of contributions. 

Submitted by Alan - IRA critic on Sun, 2020-12-06 23:00

SInce his wife had only 1 IRA worth 30k with 29k basis, all he has to do is have it titled as an inherited IRA, then take a  total distribution of 30k. The taxable amount would only be 1k. If instead he assumed ownership and as a result owned an IRA of 560k with 58k of basis, a distribution of 29k would have a taxable portion of 26k, so he would recover the combined basis very slowly over many years. 

Submitted by David Mertz on Sun, 2020-12-06 01:06

There are no separate pre-tax and nondeductible IRAs.  The wife’s basis in nondeductible traditional IRA contributions is not isolated in any particular one of his wife’s IRAs.  Her basis is spread across the total of her IRAs no matter which of the wife’s IRAs received the contributions that were not deducted.  The same is true for his own IRAs.

Submitted by John Boyle on Mon, 2020-12-07 00:48

But let’s say the wife had a $100k pre-tax IRA, and the $30k ($29k basis) Ira, can he assume the $100k as his own, then move (isolate) the $30k to an inherited IRA, then close the inherited IRA (and pay tax on the $1k)? This would eliminate the pro-rata issue at least on her IRAs. Does that sound correct? Thank you

Submitted by Alan - IRA critic on Mon, 2020-12-07 02:16

  • Yes, a surviving spouse has the option to assume ownership on an account by account basis, or could transfer just part of a single IRA to the surviving spouse’s own IRA. But any basis also moves pro rata in this situation. It is not locked down to any particular IRA account.
  • In your example, the wife’s IRAs total 130k with 29k of basis. If he assumed ownership of the 100k IRA, which is 76.9 of her total balance, he would have also receive 76.9% of her basis, which is 22,301. That would leave a basis of 6,699 in the inherited IRA account. If he then cashed out the 30k inherited IRA, 23,331 would be the taxable amount (30k less basis of 6,699). The basis that migrated to his own IRAs would be the 22,301 and when added to the 29,000 of basis he had all along, he would now have basis in his own IRAs including the 100k IRA he assumed, of 51,301. Again, no basis is lost, it is just reallocated due to assumption of ownership of one of her IRAs.

Submitted by John Boyle on Mon, 2020-12-07 02:33

To throw a curveball here, what if the $100k was instead in her 401k, that he assumed as his own, then rolled to his IRA?

Submitted by Alan - IRA critic on Mon, 2020-12-07 14:54

A 401k cannot be assumed by any beneficiary. It would have to be retitled in beneficiary form and then directly rolled over to survivor’s own or beneficiary IRA. Any 401k distribution from a beneficiary 401k account would be taxable according to how much basis there was in the 401k from after tax contributions.

Submitted by John Boyle on Mon, 2020-12-07 15:21

What I meant was: the husband assume the wife’s 401k as his own (by moving it to his traditional IRA), and receiving the wife’s $30k IRA (with the $29k basis) in an inherited IRA. That would bring his overall traditonal IRA balance to $400k, and he’d now have a $30k inherited IRA. Can he then distribute the entire inherited IRA, and pay tax only on the $1k, or does he still have a pro-rata issue somewhere? Thanks again Alan. 

Submitted by Alan - IRA critic on Mon, 2020-12-07 15:51

Remember, any basis in an inherited account remains with that account. It is not combined with an owner’s basis until such time as the inherited account is assumed by the surviving spouse. Distributions from the inherited account disregard all basis in the owner’s account.  Therefore, as long as the inherited 30k IRA is cashed out, taxes will only be due on 1k of it. 

Submitted by John Boyle on Mon, 2020-12-07 17:50

Excellent. Thanks for all of your help.

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