After tax contribution to IRA diluted with pre-tax money - how to carry it forward properly

[Boyan]

Hi everyone,

How does one properly document any after tax contribution into an IRA which already has pre-tax money? Specifically I read that there's a form which must be filed every year for the life time of the IRA so that one day when distributions start streaming out of the IRA the after-tax balance (which was once deposited years ago) will not be taxed. TurboTax properly documents this and generates the form to be carried forward every year but what happens if the chain breaks, meaning one loses a hard drive for example and the next year TT is filed with no prior knowledge of this?

Can one resume the filing of said form and how would that work?

Thanks

Boyan

[Anonymous_]

@dmertz 

[Opus 17]

Your tax return must include form 8606 any time you make a non-deductible IRA contribution, or make a withdrawal or conversion from an IRA that has a non-deductible basis.  However, form 8606 is not generated for a year in which you neither make a non-deductible contribution or withdrawal.

Any year that you have a non-deductible contribution or withdrawal, you must enter the information from the most recent previous form 8606 and it will be combined with your current year information to generate a new form 8606.   For example, if you made non-deductible contributions in 2019 and 2020 and 2022, but not 2021, your 2022 tax return would require information from your 2020 form 8606.   Your tax program will carry this information forward, but you can also manually enter the information as long as you have a copy of your prior form. (Such as if you change tax software, change accountants, or have a data loss.)

When you make IRA withdrawals or conversions, including in retirement, your withdrawal or conversion is only partly non-taxable if you can prove you made previous non-deductible contributions and reported them correctly.  Don't count on the IRS to keep track for you.  For that reason, I would make sure to save copies of any form 8606 that you file for the rest of your life (yes, really), either paper copies or PDFs or something else.  Form 8606 breaks the usual rule that you can discard tax papers after 3 or 7 years.  You probably won't be audited, but if you are, you can be asked to prove that you made non-deductible contributions and reported them properly at the time.  

(To clarify:  To file a correct tax return, you only need the most recent prior 8606, so you at least need to save that tax return.  However, in case of audit, you could be asked to show your past 8606s as well, to prove your numbers add up, so it would be a good idea to save them all.)

[Boyan]

@Opus 17 Thank you. I somehow suspected this will involve a "life sentence" for making the error of mixing moneys into an IRA and thank you so much for clarifying it in such a clear and straightforward way.

[Opus 17]

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@Boyan wrote:

@Opus 17 Thank you. I somehow suspected this will involve a "life sentence" for making the error of mixing moneys into an IRA and thank you so much for clarifying it in such a clear and straightforward way.

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The only way out is to do a full conversion of your entire IRA amount (all IRA accounts) into a Roth IRA.  You will pay the tax on the pre-tax part of the conversion, and then with a zero balance in traditional IRAs, you can re-open a traditional IRA the following year and keep it pre-tax only.  Depending on the amount, your current tax rates and so on, you might want to do that.  Otherwise you are stuck with the form 8606.  There's no way to rollover or convert only the after-tax amount.

[dmertz]

That's not the only way out.  Because only pre-tax money in your traditional IRAs is permitted to be rolled over to a qualified retirement plan like a 401(k), if you have such a plan that will accept the rollover, you can roll the pre-tax money to the plan and convert to Roth the remaining after-tax portion of your traditional IRAs.

[Opus 17]

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@dmertz wrote:

That's not the only way out.  Because only pre-tax money in your traditional IRAs is permitted to be rolled over to a qualified retirement plan like a 401(k), if you have such a plan that will accept the rollover, you can roll the pre-tax money to the plan and convert to Roth the remaining after-tax portion of your traditional IRAs.

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Interesting.  Be aware, however, that most 401k plans will not allow you to withdraw funds until after you retire or separate from service.  So putting your deductible IRA money into the 401(k) in order to separate out the non-deductible money will leave your funds stuck in the 401(k), which might not have the investments you would prefer.  

Now if you were really clever and the circumstances were right, you might be able to plan to rollover the IRA into your 401(k) just before you quit to change jobs or retire.  Once you quit or retire, you could rollover part or all of your 401(k) money (which now includes the old IRA) into a new IRA.   

[fanfare]

The third way out is to abandon your prior years basis, forget about Form 8606 and pay income tax again on that non-deductible contribution in your golden years - assuming you ever draw down to zero.

Even with the Form 8606 you will always pay income tax on the tax-deferred earnings from that contribution.

[Boyan]

@Opus 17 Thank you the reply. If I may clarify, IMHO you're making 2 points about the IRA situation:

So putting your deductible IRA money into the 401(k) in order to separate out the non-deductible money will leave your funds stuck in the 401(k)

Very true but is it not the opposite actually, where funds are more "stuck" in an IRA than in a 401(k) since the rule of 55 only applies to 401(k) and not IRA meaning there's no chance of ever taking penalty free funds out of an IRA before 59 and 1/2 while there's some chance of doing that earlier from 401(k)?

Your second point is very true - 401(k), which might not have the investments you would prefer.  

I totally agree that IRA permits trading at will with access to the open market while most 401(k) have limited and structured "portfolio" investment options controlled by the custodian (with some notable exceptions of brokerage trading window that very few permit)

[Opus 17]

@Boyan 

Really, my point is to be aware of the differences between plans because the rules are different.  Moving money into a 401(k) may have some advantages but may also have disadvantages.  Some examples:

IRA	401(k) or other qualified workplace plans
Unlimited investment choices	Investment choices may be limited by the employer
Unlimited withdrawals any time for any reason (may be subject to a penalty)	No withdrawals while you are employed by the plan sponsor, unless the plan allows for hardship withdrawals and you meet the plan's definition of hardship (withdrawals still subject to penalty).  (**A plan may permit employees to make withdrawals after age 59-1/2 even if they continue to work, but is not required to permit such withdrawals.)
Some options for penalty-free withdrawal such as higher education expenses, first time home buyer, or medical expenses during a period of unemployment	Many fewer options for penalty-free withdrawal; first time home buyer, medical expenses and higher education expenses not penalty-free https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distri...
Penalty-free withdrawals after age 59-1/2	Penalty-free withdrawals at age 55, but only if you separate from service from the plan sponsor.  (If you have a 401(k) with company A and separate before age 55, you are not penalty-free until age 59-1/2, even if you become unemployed or retire.)

Since you mentioned earlier withdrawals from the 401(k), make sure you understand that last point, it's only penalty-free at age 55 if you separate from service from the plan sponsor at age 55 or older.  If you worked for company A until age 50, then switched to company B, and you retire from company B at age 56, you can withdraw your qualified plan from company B, but you can't withdraw your funds from company A without penalty until age 59-1/2.  (You can avoid that if you rollover over your plan from company A into company B before you separate, but you have to plan ahead, remember to actually do it, and company B has to accept rollovers.)  If you work for company A and separate at age 54, and don't get a new job, or your new job doesn't have a plan that accepts rollovers, your company A funds will incur a penalty unless you wait until age 59-1/2.  Also, your workplace plan might not permit any withdrawal even after age 59-1/2 if you are still employed with the sponsor. 

If you understand the limitations and differences in the rules, and still feel that rolling over your IRA into a workplace plan meets your investment needs (so you can split out the after-tax basis and convert it to a Roth IRA), then go ahead.