Nondeductible IRA Reporting
Rev. 12/29/05, E-mail Alert 2005-26

Tracking nondeductible Individual Retirement Account (IRA) contributions, which is the responsibility of individual IRA owners, is somewhat different than tracking nondeductible contributions to a qualified plan.

Why does a qualified plan recordkeeper wish to know about this?
When advising clients about directly rolling after-tax funds to an IRA, it is important to understand the impact of after-tax dollars on the recordkeeping of a traditional IRA.
In a qualified plan, post-1986 after-tax voluntary contributions are to be distributed pro-rata as part of periodic payments such as required minimum distributions. Generally, it is the Plan Administrator’s responsibility to determine how much of a qualified plan distribution is taxable and how many after-tax dollars, if any, are being distributed. Thus, the Plan Administrator is involved in the tracking of the value of each participant’s after–tax dollars. The administrator is only responsible for the current plan in which the employee is participating and does not have any responsibility for tracking amounts accumulated in a plan of another employer in which the participant may have participated. Thus, each qualified plan stands alone; this is not the case for IRAs. When participants ask the plan administrator about directly rolling his or her entire qualified plan balance, including after-tax dollars, to an IRA, it would be important to inform the participant about the affect of having after-tax dollars in an IRA.

IRA Deductible-Nondeductible Tracking Issue
The IRA holder is responsible for tracking any after-tax dollars in his or her own IRA. Unlike the qualified plan procedures, this responsibility to account for after-tax contributions extends to all of the individual's IRAs and after-tax amounts are aggregated. Therefore, the IRA owner must combine the balance in every IRA owned and track any after-tax amounts as a ratio of the total balance of all the IRAs. This tracking responsibility continues until the IRA holder closes all of his or her IRAs, which is unlike the qualified plan world. Let’s look at an example.

IRA accountholders use Form 8606 that requires tracking of Basis by the IRA owner for total of all IRAs.
Until withdrawals begin, each institution could track the nondeductible amount held in their institution. The tracking is based solely on the information provided by the taxpayer; since the institution has no way of actually verifying the tax status of the contribution amounts. Typically, the institutions do not or are unable to coordinate with other institutions. Thus, most institutions do not track the nondeductible portion of a traditional IRA and leave the responsibility solely to the individual.

In the example above, if the IRA Owner takes a distribution of $5,000 from any IRA, the basis is calculated as follows:

$12,000/$46,000 times $5,000 = $1,304.35

The IRS Form 8606 takes the IRA owner through this calculation and leaves the IRA owner at the point where $1,304.35 has been subtracted from the previous total basis of $12,000 to arrive at a new basis of $10,695.65.

Can IRA institutions track the after-tax amount in an IRA?
Definitely, if the institution has the only IRA owned by the individual. However, in this example, this individual has three IRAs at three separate institutions.

The institution from which the distribution had occurred would have no idea of the individual's total basis and would not be able to adjust the account basis appropriately as the individual usually doesn’t even know about the need to do the calculation until they file their 8606 with their 1040. Further, the individual is very unlikely to inform the institution of his or her other IRAs since this is not legally required. The other institutions would be unaware that the basis they were tracking required adjustment.

The tracking situation would only get worse if in another year the individual takes a distribution from an IRA held at a different Institution. For example, the individual may take a distribution of $3,000 from another IRA. The tax calculation is completed again using the $10,695.65 basis balance as of 12/31 of year before distribution occurred hypothetically $46,000 less $5,000 = $41,000. The correct tax calculation would be as follows: $10,695.65/$41,000 x $3,000 = $782.61. The total basis is then reduced by $782.61 to $9,913.04. Because none of the institutions would have knowledge of the others, all three institution's basis tracking would be erroneous.

Therefore, complete and accurate recordkeeping by the IRA owner is required to avoid incorrect tax filings. Keep in mind that this tracking of IRA basis could have been avoided if the participant does not directly roll after-tax amounts to an IRA (and the IRAs contain no other nondeductible amounts).

Following is a client question (from E-mail Alert 2005-9, May 12, 2005) which illustrates how a client was able to avoid rolling after-tax dollars to an IRA when requesting a direct rollover of the participant's 401(k) balance to an IRA.

May a retiring 401(k) plan participant with a $1 million account balance that includes $80,000 in after-tax contributions request a direct rollover to an IRA of the pretax amounts only and take a distribution of the after-tax dollars?

Yes. The Job Creation and Worker Assistance Act of 2002 (JCWAA) establishes an order for rollover amounts. Under the Act, an individual is permitted to first roll over pre-tax dollars. Once all pre-tax amounts are rolled over, the individual may directly roll over the after-tax dollars to another qualified plan or an IRA. In the example in this question, as long as the participant arranges for the pre-tax amount of $920,000 to be directly rolled into an IRA, then the participant may either take the after-tax amount of $80,000 as a direct distribution or directly roll it over into the IRA.


McKay Hochman Rollover Portability Chart
IRS Form 8606 (2007)
IRS Form 8606 Instructions (2007)

Bill Grossman, QPA