Is the Total Amount of Your Contributions Less Total Distributions Taxable?
Understand how contributions and distributions impact the taxable portion of your retirement savings and learn key rules for accurate tax reporting.
Taxes on retirement account withdrawals can be confusing, especially when dealing with pre-tax and after-tax contributions. Many investors wonder whether they owe taxes on the difference between their total contributions and distributions. The answer depends on how the contributions were made and the tax rules governing withdrawals.
Understanding how contributions affect taxation is essential for avoiding unexpected tax bills. Proper recordkeeping and knowing how to calculate the taxable portion help ensure compliance with IRS rules.
Pre-Tax vs. After-Tax Contributions
Retirement contributions are taxed differently depending on whether they are made with pre-tax or after-tax dollars. Pre-tax contributions, commonly associated with traditional 401(k) plans and traditional IRAs, lower taxable income in the year they are made, providing an immediate tax benefit. However, withdrawals in retirement are taxed as ordinary income based on the account holder’s income at the time.
After-tax contributions do not reduce taxable income in the year they are made. These contributions are made with money that has already been taxed, so they are not taxed again when withdrawn. However, any earnings on these contributions are taxed as ordinary income unless they are in a Roth account, where qualified withdrawals are tax-free.
If an account contains both pre-tax and after-tax funds, withdrawals must be tracked to determine the taxable portion. The IRS requires a proportional calculation rather than allowing individuals to choose which type of money is withdrawn first.
Calculating Your IRA Basis
The taxable portion of an IRA distribution depends on the account’s basis, which is the total amount of after-tax contributions made over time. This ensures that non-deductible contributions are not taxed again upon withdrawal.
To establish the correct basis, individuals must maintain records of non-deductible contributions reported on Form 8606. This form documents after-tax contributions to a traditional IRA and must be filed each year such contributions are made. Without this documentation, proving the tax-free portion of a distribution can be difficult, potentially leading to the entire withdrawal being taxed.
The IRA basis does not include earnings or pre-tax contributions, as those amounts are fully taxable when withdrawn. For example, if someone contributed $30,000 in non-deductible funds and the account grew to $50,000, only the $30,000 represents the basis. The remaining $20,000 consists of earnings that will be taxed upon distribution. Withdrawals must be calculated proportionally based on the total account balance.
The Pro Rata Application on Distributions
When withdrawing funds from a traditional IRA containing both pre-tax and after-tax dollars, the IRS requires that distributions follow the pro rata rule. This ensures that each withdrawal consists of a proportionate mix of taxable and non-taxable funds.
The formula for applying the pro rata rule considers the total after-tax contributions as a percentage of the overall IRA balance, including earnings and pre-tax amounts. For example, if an individual has a total IRA balance of $100,000, with $20,000 representing after-tax contributions, then 20% of any distribution will be tax-free. The remaining 80% will be taxed as ordinary income.
The IRS requires that all traditional IRAs owned by an individual be aggregated for this calculation. Even if after-tax contributions were made to only one IRA, the pro rata rule applies across all traditional IRAs combined. This can complicate tax planning, especially for those who have rolled over pre-tax funds from a 401(k) into an IRA, increasing the taxable portion of future distributions.
Reporting Requirements and Recordkeeping
Accurate tax reporting for IRA distributions requires compliance with IRS documentation rules. Form 1099-R, issued by financial institutions, reports the total amount withdrawn during the tax year but does not distinguish between taxable and non-taxable portions. Taxpayers must reconcile this information on their personal returns, specifically on Form 8606, to properly allocate the tax-free portion of any distribution.
Maintaining long-term records is also important. The IRS can audit tax returns going back at least three years, but in cases of substantial underreporting, this period extends to six years or longer. Keeping copies of Form 5498, which reports IRA contributions, and prior Form 8606 filings provides a verifiable history of after-tax contributions. Without these records, the IRS may assume all withdrawals are fully taxable, increasing potential liabilities.