What’s the Basis for That?
Even though there is not much one can do to reduce taxes these days, I still enjoy reviewing client tax returns. There is a lot to learn about a client’s financial life through their tax return, and I usually come away from a review with at least one discussion point. With software driving so much related to tax preparation, taxpayers are not asked to be aware of specific rules regarding more transactional taxable events. TurboTax is the de facto expert that many defer to, without thinking of questioning any output that isn’t out of line with our expectations. As an example, we are seeing more issues regarding distributions from retirement accounts and how they are represented on the tax return.
First, a quick history of the individual retirement account (IRA) and Roth IRA. Deductible IRAs (in which you could contribute and take a tax deduction) were introduced in 1974 as a savings vehicle for those without pensions. From 1982 to 1986 all workers younger than 70.5 could make tax-deductible contributions up to $2,000 and non-working spouses could contribute $250. The Tax Reform Act of 1986 imposed restrictions on deductible IRA contributions based on participation in an employer-sponsored retirement plan and income levels. In 1998 deductible contributions were expanded for married couples where only one spouse was covered by a retirement plan. Despite limits based on income or retirement plan participation, all workers could still contribute to an IRA, just without tax deductibility or limited tax deductibility. As if the complexity of IRA deductibility was not confusing enough, the Roth IRA was also introduced in 1998. Contributions to the Roth IRA are limited based on income only, regardless of participation in another retirement plan.
Both the non-deductible IRA and the Roth IRA have cost basis, amounts contributed after-tax, which is important to track for potential tax reasons. Cost basis in an IRA is applied on a pro-rata basis and helps lower the tax impact of any distributions you take. For example, if you take a $20,000 distribution from a $100,000 IRA that has a cost basis of $5,000, your taxable amount is $19,000 ($5,000/$100,000 = 0.05 * $20,000 = $1,000 non-taxable amount/ $19,000 taxable). This is also the calculation that you would need to make if you were to convert all or part of an IRA to Roth IRA.
One mistake we’ve seen is the taxpayer applying the entire cost basis to one distribution, thus significantly reducing or eliminating the taxable impact of the distribution. It is not possible to apply to IRA cost basis either tactically or arbitrarily. You need to make a pro-rata calculation that spreads the cost basis over the life of the IRA. Note that it is entirely possible that your IRA has no cost basis, particularly if it was a rollover from an employer retirement plan in which you only contributed pre-tax earnings.
Another mistake we’ve seen is in Roth conversions – specifically through so-called back-door Roth contributions. For context, the income limitations for making Roth contributions means that high income earners will not be able to contribute directly to Roth IRA. Note that a Roth option in an employer-provided retirement plan is available to all participants, regardless of income.
Savvy individuals know that a work around for the income limitation is to make a non-deductible IRA contribution and then convert it to a Roth IRA in a short period of time, thus reducing or eliminating the potential tax on the conversion. This is the back-door Roth contribution strategy. However, if you have IRA balances, then the backdoor Roth is not as clean an option. The entire balance of all IRAs needs to factor into the taxable amount of the conversion. In other words, you cannot take a last-in-first out approach to a Roth conversion with existing IRA balances.
All the different rules around contributing to IRAs, Roth IRAs and retirement plans can create a lot of confusion. But if you are contributing to one or more retirement vehicles it is worth knowing how those contributions will be taxed when you need to pull them out for cash flow purposes. When in doubt, feel free to reach out to your relationship manager or a member of the financial planning team to review your distribution strategy and its potential tax impact.
Meet Kristan L. Anderson, CEBS®, CFP®
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