Notice 87-16: IRA Contribution and Distribution Rules
Explore the foundational IRS rules for IRAs containing after-tax funds. This guidance clarifies how to track your basis and determine the tax on distributions.
The Internal Revenue Service (IRS) issued Notice 87-16 as guidance for the changes to Individual Retirement Arrangements (IRAs) from the Tax Reform Act of 1986. This legislation created new rules for the deductibility of IRA contributions and introduced nondeductible contributions. Notice 87-16 established the foundational principles for reporting these contributions and calculating taxes on distributions from IRAs that contain both pre-tax and after-tax funds.
Designating and Reporting Nondeductible Contributions
A nondeductible IRA contribution is a deposit to a traditional IRA for which the account owner does not take a tax deduction. This situation arises when an individual participates in a workplace retirement plan, like a 401(k), and their modified adjusted gross income exceeds the annual limits for deducting contributions. These contributions create “basis” in the IRA, which is the total amount of after-tax money in the account.
Notice 87-16 requires taxpayers to formally designate and track nondeductible amounts to prevent double taxation. Without proper records of this basis, the IRS considers all distributions to be from pre-tax funds and therefore fully taxable. Proper documentation ensures the after-tax basis can be returned tax-free upon withdrawal.
The mechanism for this reporting is IRS Form 8606, Nondeductible IRAs. This form must be filed for any year a nondeductible contribution is made and for any year a distribution is taken from a traditional, SEP, or SIMPLE IRA if the owner has ever made nondeductible contributions. To complete Form 8606, a taxpayer needs the nondeductible contribution amount for the year, the total basis from previous years, and the total value of all their IRAs as of December 31. Failure to file Form 8606 can result in a $50 penalty, while overstating the nondeductible amount carries a $100 penalty.
Calculating the Taxable Portion of Distributions
When taking a distribution from a traditional IRA containing both pre-tax and after-tax funds, a specific calculation determines the taxable amount. Notice 87-16 introduced two concepts that govern this process: the aggregation rule and the pro-rata rule. These rules ensure a portion of each distribution is a tax-free return of basis, while the remainder is taxed as ordinary income.
The aggregation rule requires that for this calculation, all of an individual’s traditional, SEP, and SIMPLE IRAs are treated as a single account. An account holder cannot withdraw funds from one IRA and designate it as a tax-free return of basis. The total year-end value of all such IRAs must be summed to prevent individuals from isolating their after-tax money.
The pro-rata rule determines the percentage of the distribution that is nontaxable. The calculation is made by dividing the total basis by the combined value of all traditional, SEP, and SIMPLE IRAs at year-end, plus any distributions taken during that year. This ratio represents the proportion of the total IRA funds that consists of after-tax money.
For example, assume an individual has a total IRA basis of $20,000. The total value of all their traditional IRAs on December 31 is $80,000, and they took a $10,000 distribution during the year. The total account value for the calculation is $90,000 ($80,000 + $10,000). The nontaxable percentage is 22.2% ($20,000 basis / $90,000 total value). Of the $10,000 distribution, $2,220 is a tax-free return of basis, and the remaining $7,780 is taxable income.
Rules for Rollovers and Transfers
The principles of Notice 87-16 also apply to rollovers and transfers. When the entire balance of all traditional, SEP, and SIMPLE IRAs is rolled over into another traditional IRA, the basis moves with the funds to the new account. No tax is due, and the basis amount remains unchanged.
A partial rollover, where only a portion of a distribution is moved to another IRA within the 60-day window, is handled differently. The initial withdrawal is subject to the pro-rata calculation. The portion that is rolled over is considered to come proportionally from the pre-tax and after-tax amounts of the withdrawal, and its associated basis is added to the destination IRA.
A distinction exists between a rollover and a direct trustee-to-trustee transfer. A rollover is a reportable distribution where the account holder receives the funds before re-depositing them. A direct transfer moves funds between institutions without the owner taking control, so it is not a distribution and does not trigger the pro-rata calculation.
A “reverse rollover” moves pre-tax funds from an IRA into an employer plan like a 401(k), but only if the employer’s plan accepts such transfers. Government rules allow only pre-tax money to be moved this way. This isolates the after-tax basis in the traditional IRA, which can be advantageous for a future Roth IRA conversion, as that conversion would then be largely or entirely tax-free.