Recouping nondeductible contributions to traditional IRAs.

An individual who makes nondeductible contributions to a traditional (versus Roth) IRA acquires basis therein. Thus, a portion of each distribution will be a nontaxable return of basis; see Secs. 72(e) and 408(d). Unfortunately, except for certain rollover situations, a taxpayer cannot withdraw the nondeductible portion (basis) before withdrawing amounts includible in taxable income. Accordingly, each distribution has both a nontaxable and taxable component.

Note: Contributions to a Roth IRA are nondeductible, but earnings build up tax flee; taxpayers can eventually take out qualified distributions and related earnings without paying taxes. In addition, Roth IRA contributions can be withdrawn tax free at any time; nonqualified distributions are treated as made from contributions first.

Nontaxable Portion

In a year in which no IRA distributions have been rolled over to a plan other than another IRA, the nontaxable portion of current-year traditional IRA distributions (that are not rolled over) is calculated as follows:

Total nondeducatible contributions/ IRA account balances in all IRAs at IRA year-end + Amount distributed during year + Outstanding rollover x IRA distributions = Nontaxable portion of IRA distributions

"Outstanding rollover" means any amounts distributed before year-end, but rolled into another IRA in the following year under the 60-day rollover rule.

When calculating the nontaxable portion of distributions, the total fair market value (FMV) of all traditional IRAs the individual owns (including simple employer plan (SEP)-IRAs, savings incentive match plan for employees (SIMPLE)-IRAs and other traditional IRKs containing funds rolled over from a qualified plan), must be included in the computation. (The individual cannot use only the IRA from which the distributions were received.) The FMV of all IRAs at year-end includes both realized and unrealized appreciation of IRA assets; Roth IRAs are not considered.

Example 1

Dan, age 60, has four traditional IRA accounts; their FMVs on June 30, 2006 were as follows:

Account   FMV

1         $20,000
2          22,000
3          43,000
4          10,000
Total     $95,000

Dan has made nondeductible contributions totaling $10,000 to account #4. He has made no other nondeductible

contributions, and would like to withdraw his $10,000 nondeductible contribution from account #4. Can he do so tax free?

No. Dan cannot withdraw the nondeductible portion (basis) before withdrawing the amounts treated as taxable income. He must include the value of all IRA accounts in calculating the nontaxable portion of the distribution.

If Dan takes a $10,000 distribution from account #4 and the FMV of all his IRA accounts at the end of 2006 is $90,000 (after reduction by the $10,000 distribution), the nontaxable portion of his distribution is calculated as follows:

$10,000/$90,000 + $10,000 x $10,000 = $1,000

Accordingly, $1,000 of the distribution is h return of basis; the remaining $9,000 is taxable income, even though the value of account #4 was made up entirely from nondeductible contributions.

Planning Tip

Individuals who have taken a distribution from a nondeductible traditional IRA during the tax year and are contemplating rolling over a lump-sum distribution from a qualified plan into an IRA should consider deferring the rollover into the following year, if possible. This will keep the IRA account balances lower during the distribution year, thus allowing a higher basis calculation for the distribution from the nondeductible IRA and lowering the taxable amount from that distribution.

Example 2

The facts are the same as in Example 1, except that Dan is contemplating taking a $400,000 lump-sum distribution from his former employer's plan and rolling it over into a traditional IRA in December 2006. If he does so, the nontaxable portion of the $10,000 distribution from the nondeductible IRA will decrease to $200 [$10,000/($100,000 + $400,000) x $10,000]. However, if he waits until January 2007 to take the distribution from the employer plan and roll it over, there is no effect on the IRA balances in 2006 and the nontaxable portion of the $10,000 IRA distribution remains at $1,000.

Observation: Individuals who have made nondeductible contributions should have filed (and retained) copies of Form 8606, Nondeductible IRAs, for each year such contributions were made. If the individual failed to file Form 8606 to report nondeductible contributions, the contribution is presumed to have been deductible. This presumption can be rebutted with satisfactory evidence that the contributions were nondeductible. Presumably, copies of prior-year returns showing no deductible IRA contribution would suffice.

Recommendation

The potential for an IRA contributor to increase his or her retirement income can be significant, as all income and realized gains in the account are accumulated tax-deferred. Thus, the additional filing requirements and computations for nondeductible contributions and distributions should not deter a taxpayer from making nondeductible IRA contributions. However, when available, a nondeductible contribution to a Roth IRA will often be preferable.

Losses

It is possible for an individual to recognize a loss in the year an IRA is liquidated. If the basis in the account exceeds the total value of IRA distributions in the final year, a loss is recognized on the IRA distribution; see Notice 89-25 .The taxpayer may recognize a loss only when all amounts in all IRAs have been distributed, and total distributions are less than unrecovered basis; see Notice 87-16. The deductible loss (i.e., the excess of basis over liquidating distributions) is an itemized deduction subject to the 2%-of-adjusted-gross-income floor.

Editor's note: This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 7th Edition, by Anthony J. DeChellis and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ([phone]; ppc.thomson.com).

Editor: Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, E.L.P.

Arlington, VA