Traditional individual retirement accounts are funded with pre-tax dollars. As a result, most distributions from a traditional IRA are taxable as ordinary income. However, some distributions can be made tax free. If you make after-tax contributions to an IRA, which are also known as nondeductible contributions, then you don't get a tax deduction. Since you already paid tax on these contributions, they become your IRA basis, and they aren't taxed again when you withdraw them. If you have made both deductible and nondeductible IRA contributions, then you'll have to calculate the ratio between the two in order to determine the taxable portion of a traditional IRA distribution.
Track Your Nondeductible Contributions
You'll have to keep track of your nondeductible IRA contributions if you want to calculate your IRA basis. If you make a nondeductible contribution to a traditional IRA, then you should file IRS Form 8086 with your tax return each year. Form 8086 documents your IRA basis so you know how much you have in nondeductible contributions. This information is important because you won’t have to pay taxes on your IRA basis when you take a distribution.
Add up all of your nondeductible contributions to date. Subtract any previous nondeductible contributions that you’ve already removed from the IRA. The result is your IRA basis.
Divide the IRA basis by the balance in your traditional IRA account in order to find the percentage of the balance that is your IRA basis. For example, if you have a balance of $75,000 and an IRA basis of $15,000, then divide $15,000 by $75,000, which works out to 20 percent.
Multiply the amount of the traditional IRA distribution by the percentage of IRA basis. If the basis percentage is 20 percent and you take out $10,000, you would multiply $10,000 by 20 percent, which equals $2,000.
Subtract the IRA basis part of the distribution from the total distribution. In the example, you would subtract $2,000 from $10,000, leaving $8,000. This is the taxable portion of the traditional IRA distribution.
Understand IRS Income Limits
You can wind up with nondeductible contributions to a traditional IRA when you or your spouse is covered by a retirement plan where you work. If this is the case, then the IRS sets income limits. If your adjusted gross income exceeds these limits, you can still make contributions up to the annual limit, but they are not tax deductible.
- You can wind up with nondeductible contributions to a traditional IRA when you or your spouse is covered by a retirement plan where you work. If this is the case, the IRS sets income limits. If your adjusted gross income exceeds these limits, you can still make contributions up to the annual limit, but they are not tax deductible.
John Csiszar served as a financial adviser for over 18 years, both for a global wirehouse and at his own investment advisory firm, earning a Certified Financial Planner designation along the way. He now works as a writing and editing contractor for private clients, with thousands of online articles to his credit, along with five educational books written for young adults.