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Most retirement plan participants use pretax assets to fund their employer-sponsored plans such as 401(k) and 403(b) accounts, or they claim a tax deduction for amounts contributed to their Traditional IRAs. In both cases, these contributions can help to reduce the individual’s taxable income for the year to which the contribution applies. However, it is also possible to contribute amounts to employer-sponsored plans on an after-tax basis, and for IRAs, contributions can be non-deductible. The advantage of accumulating after-tax assets in a retirement account is that when they are distributed, the amounts will be tax- and penalty-free. However, this benefit is realized only if the necessary steps are taken.
Keeping Track of Your After-Tax Assets
Reaping the benefits of this strategy starts with good record-keeping and clear communication with your plan administrator and the IRS.
Your Qualified Plan Account
The administrator for your qualified plan is responsible for keeping track of which portion of your balance is attributed to after-tax assets and pretax assets. However, it helps if you check your statements periodically to ensure that the tabulations match what you think they should be. This will allow you to clarify possible discrepancies with the plan administrator.
Your IRA custodian is not required to keep track of the after-tax balance in your IRA, and most, if not all, do not. As the owner of the IRA, you are responsible for keeping track of such balances, and this can be accomplished by filing IRS Form 8606.
If you make a non-deductible contribution to your Traditional IRA, or roll over after-tax assets from your qualified plan account to your IRA, you must file IRS Form 8606 for the year the amount is contributed to the IRA. While the IRS does not currently require Form 8606 to be filed for rollover of after-tax amounts, it may be a good idea to record such amounts for your records. Form 8606 lets the IRS know that the amount represents after-tax assets, and it helps you keep track of the balance of your IRA that should be tax-free when distributed. Form 8606 must also be filed for any year in which distributions occur from any of your Traditional, SEP or SIMPLE IRAs and you have accumulated after-tax amounts in any of these accounts. Make sure you read the important filing instructions that accompany Form 8606 – they provide details on the sections of the form that must be completed.
Tax Treatment of After-Tax Assets
Generally, your plan administrator will indicate the taxable portion of amounts distributed from your qualified plan account on the Form 1099-R that you receive for the year. If the amount is not properly indicated on the 1099-R, you may want to request written confirmation from the plan administrator of the portion of the distribution that is attributable to after-tax assets. This will help to ensure you include the correct amount in your taxable income for the year.
With the exception of ‘return of excess contributions,’ your IRA custodian is not required to make a distinction between the taxable and non-taxable portion of amounts distributed from your Traditional IRA. You must provide that information on your income tax return by indicating the entire amount of the distribution versus the amount that is taxable. For more information, see the instructions for line 15a of IRS Form 1040. The aforementioned Form 8606 will help you determine the taxable and non-taxable portions of amounts distributed from your Traditional IRA.
Pro-Rata Treatment of Distributions
If your qualified plan or 403(b) account or Traditional IRA includes after-tax amounts, distributions usually include a pro-rata amount of your pretax and after-tax balance. For this purpose, all of your Traditional, SEP and SIMPLE IRAs are treated as one account. For instance, assume that you made an average of $20,000 in after-tax contributions to your Traditional IRA over the years and your Traditional IRA also includes pretax assets of $180,000, attributed to rollover of pretax assets and deductible contributions. Distributions from your IRA will include a pro-rata amount of pretax and after-tax assets. Let’s look at an example using these numbers.
John has several IRAs, which consist of the following balances:
- Traditional IRA No. 1, which includes his non-deductible (after-tax) contributions of $20,000
- Traditional IRA No. 2, which includes a rollover from his 401(k) plan in the amount of $150,000
- Traditional IRA No. 3, which is really a SEP IRA, which includes SEP contributions of $30,000
In 2013, John withdraws $20,000 from IRA No. 1. John must include $18,000 as taxable income from the $20,000 he withdrew. This is because all of John’s Traditional, SEP and SIMPLE IRAs are treated as one IRA for the purposes of determining the tax treatment of distributions, when John has basis (after-tax assets) in any of his Traditional, SEP or SIMPLE IRAs.
The following formula can be used to determine the amount of a distribution that will be treated as non-taxable:
Basis / Account Balance x Distribution Amount = Amount Not Subject To Tax
Using the figures in the example above, the formula would work as follows:
$20,000 / $200,000 x $20,000 = $2,000
Since IRS Form 8606 includes a built-in formula to determine the taxable amount of distributions from your Traditional IRAs, you may not need to use this formula for distributions from your IRA.
For qualified plan accounts that include a balance of after-tax amounts, distributions are usually pro-rated to include amounts from pretax and after-tax balance. This means that, similar to IRAs, you can’t choose to distribute only your after-tax balance. However, certain exceptions apply. For instance, if your account includes after-tax balances accrued before 1986, these amounts may be distributed in full, resulting in the entire amounts being non-taxable, rather than being pro-rated.
Rollover of After-Tax Balance
If your retirement account balance includes after-tax amounts, whether these amounts can be rolled over depends on the type of plan to which the rollover is being made.
The following is a summary of the rollover rules for these amounts:
- IRA to IRA: All rollover eligible amounts can be rolled over to an IRA. This includes after-tax amounts.
- IRA to Qualified Plan/403(b): All rollover eligible amounts can be rolled over to a qualified plan/403(b), provided the plan allows it. However, this does not include after-tax amounts – such amounts cannot be rolled from an IRA to a qualified plan/403(b).
- Qualified Plan/403(b) to Traditional IRA: All rollover eligible amounts can be rolled over to a Traditional IRA. This includes after-tax amounts.
- Qualified Plan/403(b) to Qualified Plan/403(b): All rollover eligible amounts can be rolled over to another qualified plan/403(b), provided the plan allows it. This includes after-tax amounts, provided these amounts are transacted as direct rollovers.
The Bottom Line
Bear in mind, this is just an overview of the rules that apply to your after-tax balance in your retirement account. Having a thorough understanding of the rules will ensure that you include the right amount in your taxable income for the year you receive a distribution from your retirement account, thereby not paying taxes on amounts that should be tax-free. As always, be sure to consult your tax professional for assistance to make sure that your after-tax assets are treated correctly on your tax return, and so that you know what tax forms to file each year.
Ben Franklin once declared, “A penny saved is a penny earned.” Yet, equally enlightening are his thoughts on expenses: “Beware of little expenses. A small leak will sink a great ship.”
And there are plenty of “leaks” that can scuttle an already-tight budget. For instance, a spouse idled by the sour economy, a fender bender with the family car, or an unexpected hospitalization. That’s why financial advisors recommend that you have a rainy-day fund—enough liquid assets to cover three to six months’ worth of emergency living expenses. In case of financial emergency, access to additional money will save you from relying on credit cards or loans that simply compound the problem.
When starting an emergency fund, here are a few tips to abide by:
- Determine what amount is best for you. Most experts agree that you should keep between three and six months worth of your living expenses set aside in your emergency fund. Your specific situation – whether you have children, carry substantial debt and types of insurance coverage you have – will determine what amount is best for you. Examine your situation — your income and your needs — to decide how much you should save.
- Start small. Starting an emergency fund can be as simple as depositing $100 into your high-interest savings account. But before you begin, be sure that you’re meeting your basic living expenses. And as you build your emergency fund, be sure you’re also reducing your spending and avoiding debt.
- Stick to a schedule. Get into the habit of making regular deposits. Whether it is weekly, bi-weekly or monthly, create a schedule and stick to it. Once you make saving automatic, you won’t even have to think about it.
- Consider an online savings account. In many cases, an “online” savings account may make more sense than an account at a traditional, bricks-and-mortar bank. That’s because many traditional banks are not currently offering a savings option with interest rates high enough to meaningfully beat inflation. In addition, an online savings account is a reliable way to manage your money.
Ideally, in retirement, you reduce your monthly expenses. No more commute, less need for work-related clothes and dry cleaning, and the ability to eat lunch at home every day. But is it enough savings to balance the lack of income from work?
If you’re like many retirees, near-retirees or even those just starting to plan for retirement income, you may have an uneasy feeling about just how much money you’ll need and how long you’ll need it to last. If you’re just not feeling confident about it, there is one thing you can do to help: Downsize.
Downsizing to a less expensive condo, townhouse, apartment or smaller home offers numerous savings advantages, from reducing your monthly mortgage or rental costs, to lower maintenance, property tax and utility bills.
If you’re thinking of moving out of state, perhaps to a locale where you’ve vacationed and dreamed of living for years, consider the pros and cons of what living there year-round may mean. Is it a dreary place in winter, or too hot in the summer? Does it feature a year-round community where you can make friends with locals, or is it pretty much abandoned when tourists or snow-birds are gone — and could you bear that? Oftentimes those lovely vacation spots can be quite isolated during the off-season.
It may come down to your basic personality and disposition: do you prefer the opportunity to make good friends and always have people around with whom to spend time, or would you be OK with getting away from it all and minimizing outside relationships, at least for part of the year? Consider, too, how your spouse’s answers may differ to those same questions.
Then, too, you should examine the practical side of relocating. For example, will the cost of living be higher or lower than where you currently live, and what can you expect in terms of health care and other expenses and amenities? After all, your large family home may not be as expensive as a tiny condo on the beach, complete with high monthly expenses and high property taxes.
If you plan to move to another state, you will need to investigate tax and estate laws to see if you’ll need to update your wills and trusts. If you have a network of trusted financial professionals and attorneys, you may want to check if they are licensed to continue working with you in the state where you want to relocate.
Then again, you could just move to a smaller place in your current neighborhood or community. You may opt to live closer to relatives, which can offer the potential for significant savings when it comes to home care in your later years. If so, consider features in a new home that will be more convenient as you venture gracefully into old age, such as a single-story home with a low-maintenance yard and accessibility features. Also think about your locale of choice — such as whether you’d like to move to a more urban scene in a trendy downtown location near art galleries, museums, fine restaurants and concert halls. Perhaps a condo with a skyline view, concierge and doorman would fit the bill. After all, if you spent the majority of your adult life raising a family in suburbia, retirement may be the time to enjoy other types of entertainment.
A third option is to move to a senior living community. According to a survey by the Demand Institute Housing & Community, one in five baby boomers is considering relocating to a senior-related housing or active-adult community. While many of these campuses have come a long way in featuring more cultural and upscale amenities, many still suffer from a reputation of the proverbial “old folk’s home.”
The key to downsizing — or what some prefer to call “right-sizing” — is to make the right decision for your lifestyle and finances. Some retirement-oriented communities may offer work and entrepreneurial opportunities so you can get out and about, make new friends and contribute to your retirement income. Do not under-estimate the value of a strong social network comprised of people of all ages. After all, if you’re going to live a long and healthy life, why not live it among friends?
- Media Post. May 15, 2015. “Redefining Senior Living for Boomers through the Name Storm Project.”
http://www.mediapost.com/publications/article/248470/redefining-senior-living-for-boomers-through-the-n.html. Accessed Aug. 5, 2015.