What Happens If You Have Post-Tax Money in Your IRA
If you’ve got an IRA that contains only pre-tax money and you take a distribution from that IRA, the taxation is pretty straightforward: the custodian reports the distribution to the IRS, and you pay ordinary income taxes on the amount you took out. If you’re under age 59 ½, then you’ll also owe an early withdrawal penalty, unless you qualify for an exception.
But what if you’ve got a mixture of both pre-tax and after-tax money in your IRA? How are the distributions taxed in that situation? Are you allowed to simply choose which type of money (pre- or post-tax) that you want to take out, and either pay (or not pay) taxes on that distribution?
In most cases, the answer is no. Current tax law says that any distribution you take from an IRA where you have a combination of pre- and post-tax money will come out pro-rata of both. So if your IRA balance is $100,000, but $90,000 of it is pre-tax and $10,000 is post-tax, and you take a distribution of $10,000, then $9,000 of that 10 grand will be taxable and $1,000 will be not taxable in this example. In other words, you can’t just remove only the $10,000 of after-tax money: it comes out pro-rata.
On top of that, you have to tell the IRS that there’s after-tax money coming out so that you don’t get taxed on it again, because in theory nobody but you knows that there’s after-tax money being distributed to you. This means you have to file form 8606 every single year that you take money out of that IRA, which tells them not to tax that portion of the distribution.
Yes, it can be a hassle, but it’s better than paying tax twice on the same money.
But if you want to get out of filing that annoying Form 8606 every year, and potentially save yourself from currently paying on that money, there are really only three ways to separate pre- and post-tax money in your IRA.
One is to transfer the assets into a qualified plan like a 401k, which by definition can NOT include any after-tax money. But not all retirement plans allow you to do that. So that option isn’t available for everyone.
Another way to do it involves a Health Savings Account, or HSA. If you’re not taking Medicare yet and you’re eligible for and have an HSA, you have a one-time option to transfer money from your IRA to your HSA up to the HSA limit for the year on a tax-free basis, which then becomes your funding source for your HSA for the year. And this can only be done with pre-tax money.
There’s no pro-rata distribution, and even better, you don’t have to file form 8606 to do it! And there’s an even bigger bonus to this: If and when you use this pre-tax money that was formerly in your IRA for qualified medical expenses, the money comes out of the HSA tax free! That’s not a bad way to go.
The other way to get just the pre-tax money out of your IRA involves charitable donations. If you’re at least age 70 ½, and you’re charitably inclined, you can give money to a qualified charity directly from your own IRA through what’s called a Qualified Charitable Distribution, or QCD. Your gift goes directly to the charity from your IRA, and by using the QCD, it comes 100 percent from the pre-tax money in that account. No pro-ration involved. The annual limit is $100,000 but it does count towards your RMD for the year. The charity gets the money, and your RMD is done for the year. No need to itemize your deductions on schedule A, no increase in your AGI, and, maybe best of all, no form 8606 to fill out.
Keep in mind, these strategies all have to be done correctly, or you could wind up paying more in taxes than you thought. And if your goal is just to avoid the hassle of Form 8606, that’s fine, but you’ll have to do some work to make that happen. On the other hand, if you’re looking to do a strategy like a backdoor Roth, it may be worth it, because having post-tax money in your IRA will mess up your ability to do that Roth 2-step – again, because of the pro-rata distribution rule.
All of this falls under the important planning category of tax management. And this is something we do for our clients every single day at Lucia Capital Group. How can we help you the most? Just give us a call.
The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.
No client or prospective client should assume that this information, or any component thereof, serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group or from any other investment professional.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.
Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.
Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.