How to Calculate Tax-Free and Taxable IRA Withdrawals
If you haven't filed Form 8606 with the IRS to track your nondeductible IRA contributions over the years, it will take a bit of detective work.
Question: I am trying to figure out how much I'll owe in taxes when I roll over some money from my traditional IRA to a Roth. I made some nondeductible contributions to the IRA a while back, so some of that money has already been taxed. How do I figure out the tax bill on the rollover?
Answer: If you made some nondeductible contributions to a traditional IRA, then a portion of any rollover or withdrawal will be tax-free. The tax-free amount is based on the ratio of nondeductible contributions to the total balance of all of your traditional IRAs. For example, if you made $5,000 in nondeductible contributions and your total balance in all of your traditional IRAs is $100,000, then 5% of any rollover or withdrawal will be tax-free.
You should have filed Form 8606 for every year you made nondeductible IRA contributions. On this form, you report that year's nondeductible contribution plus a running total of nondeductible contributions made through the years (which is your tax basis in your traditional IRA). You're supposed to file Form 8606 by the tax-filing deadline for the year you made the contribution, but many people don't realize they need to file the form because the contribution wasn't deductible. See Instructions for Form 8606 for more information about filing the form.
You will need to do some detective work if you don’t have the forms or you haven't kept them up through the years. IRA administrators should send out Form 5498 for every year you make a contribution. Many people frequently forget to keep Form 5498 because it usually arrives after they have filed their tax return. (The form must be sent by May 31 after the tax year of the contribution, so you should be receiving the form reporting 2017 contributions this month.) Form 5498 doesn't show whether your contribution was tax-deductible, but you can look at your old tax returns to see whether you deducted the contribution.
If you don't have Form 5498, look back at your brokerage statements for the IRA to see if you have any other records of contributions. "If you have had the same IRA custodian forever, they may be able to help you determine which years you made a contribution of any sort, but they do not track whether it was deductible or not," says Morris Armstrong, an enrolled agent in Cheshire, Conn. (enrolled agents can represent taxpayers before the IRS). If you don't have your old tax returns, you can order a transcript from the IRS for the past three years free, or you can order copies of full tax returns for $50 apiece. Use Form 4506 to order an old tax return.
All this effort can be worth it if you made a lot of nondeductible contributions. Steven Hamilton, an enrolled agent in Chicago and Spring Hill, Fla., recently helped a client reconstruct records to find nondeductible contributions going back to 1994. That will help her save more than $1,000 each year in taxes on her withdrawals.
It's not too late to get your records in order if you haven't kept up with them through the years. File a Form 8606 for each of the missing years so that the records will be there when you take withdrawals. Also, because IRAs are held individually rather than jointly, you and your spouse must file separate forms if both of you made nondeductible IRA contributions.
For more information about tax records to keep and toss, see When It's Safe to Shred Your Tax Records.