Retirement tax questions

CN11 · ‎April 9, 2020

There were a few inadvertent errors in my original posting. Here follows the revision:

Calculation of the federal non-taxable portion of an IRA distribution due to a basis in the IRA has little bearing upon the percentage of the IRA funding with pre-tax dollars. Form 8606 guides the calculations, and the balance of unrecovered taxed contributions from the prior tax year is applied.

Generally, distributions (RMDs and Roth conversions, but not tax-free rollovers) are added to the year-end value (V) of all IRAs to determine the total value (Vt) of the IRAs. Subtracting the unrecovered taxed contributions (U) from that total represents all earnings plus pre-tax contributions (A = Vt - U), that are fully taxable upon distribution.The ratio of the unrecovered taxed contributions U to the total value Vt establishes the fractional part of Vt that U represents. Equivalently, the ratio of A to the total value Vt establishes the fractional part that A, all earnings plus pre-tax contributions, represents.

Multiplying the ratio (U/Vt) times the amount of the distribution (D) determines the non-taxable portion of the distribution that is a partial return of the basis, and the taxable part of the distribution (Dtax) is calculated by subtracting the partial return of the basis from the distribution. For a total distribution, V = 0 and Vt = D, so that (U/Vt) * D = (U/D) * D = U; in other words, the return of your entire remaining basis is untaxed. If U = 0, you have no basis, the entire distribution is taxed with no need for form 8606.

As an example, consider that your first RMD has occurred, your pre-tax contributions were $95,000 and your after tax (taxed) contributions (U) were $5000. That conforms to your 95% and 5% funding relationship. Further consider that the year-end value (V) of your IRAs happens to be $900,000 and for an age factor of 27.40 applied to the prior year-end value of $880,000 the RMD (D) is $880,000 /27.40 = $32,117. The total value of your IRAs for the year of distribution is Vt = V + D = 900,000 + 32,117 = 932,117. The ratio of U to Vt is U/Vt = 0.0054 (rounded to 4 decimal places). Finally, (U/Vt) * D = 0.0054 * 32,117 = 173 (rounded to 0 decimal places), and is the untaxed portion of the RMD, a partial return of the basis. The taxable portion then becomes D - (U/Vt) * D = 32,117 - 173 = 31,944.

Alternatively for this example, A = Vt -U = 932,117 - 5000 = 927,117 and A/(Vt) = 927,117/932,117 = 0.9946. For D = 32,117, D * A/(Vt) = 32117 * 0.9946 = 31,943.5682 which rounds to 31944.

Consider the modified example offered by dmertz, with year-end value at $10,000 but the same distribution of $32,117 and after tax (taxed) contributions of $5000. In this case Vt = V + D = 10,000 + 32,117 and (U/Vt) * D is the nontaxable part of the distribution:

(5,000 / (10,000 + 32,117)) * 32,117

= (5,000 / 42,117) * 32,117

= 0.1187 * 32,117 = 3812 (rounded)

So the taxable part is $32,117 - $3,812 = $28,305

Using the alternative approach of A = V + D - U = Vt - U = 42,117 -5,000 = 37,117, then (A/Vt) * D yields directly the taxable part of the distribution:

(37,117 / 42,117) * 32,117

= 0.8813 * 32,117 = 28,305

and the non-taxable part is the difference of the taxable part from the value of the distribution:

$32,117 - $28,305 = $3,812

Note 1:

Form 8606 has line-by-line entry for all of the data with D provided as total ordinary IRA distributions (Dord) and total Roth conversion distributions (Drc) on separate lines (line 7 and line 8). The fraction U/Vt (line 10) is multiplied times each of those two distribution values and the resulting values of untaxed portions placed on lines 11 and 12. The sum of the two values of untaxed portions is entered on line 13, which represents the basis change for the current tax year, and is used in the calculation of the remaining basis applicable to the next tax year.

Note 2:

In case non-deductable contributions are made during the current tax year and for the current tax year during 1/1 through 4/15 of the following calendar year, Form 8606 determines the basis through the year end of the current for calculations of taxable and non-taxable portions of IRA distributions.