Or: There’s Basis In Them Thar Funds!
If you have an IRA that has certain types of funds in it, you may be in a position to have some of your distributions treated as post-tax, meaning that you will not have to pay ordinary income tax on the distribution as you normally would. But what kinds of money is considered post-tax?
The common way to have post-tax funds in an IRA is to make non-deductible contributions to the account. This occurs when you are not eligible to make deductible contributions due to income restraints, but you still wish to make IRA contributions for the year.
For example, if in 2012 you have income in excess of $112,000 ($68,000 if single) and you’re covered by a retirement plan at work, you can still contribute up to $5,000 (plus $1,000 if over age 50) to an IRA – you just can’t deduct the contribution from your income for tax purposes. See the article on 2012 Retirement Plan Limits for more details on how this works.
Another way to have post-tax funds (also known as “basis” in the IRA) in your IRA is to over-contribute funds without distributing them. This happens if you put in more than the annual limit.
In addition, if you rolled over a retirement plan that included post-tax funds, you’ve established basis in the IRA.
The last way to do this is if you made contributions to the IRA as a qualified reservist – if a reservist called to active duty after September 11, 2001 makes a distribution from a qualified retirement plan (QRP) this can be rolled over into an IRA as post-tax funds without tax or penalty. Commonly this type of distribution is either made as a rollover into a Roth IRA or just taken as cash, so this one probably doesn’t occur very often.
What Happens With the Post-Tax Money?
So, what happens when you have basis in the IRA? Even though you made post-tax contributions to the account, there is likely a portion of the account that is also pre-tax. Any other (deductible) contributions made to the account, as well as pre-tax rollovers from QRPs, and the growth of the funds in the account will be pre-tax when distributed.
In addition, all of your IRAs are aggregated when considering how the money is taxed. So, for example, let’s say you have two IRAs, one with all pre-tax money in the amount of $50,000, and another with $25,000 of basis (post-tax) and $25,000 of pre-tax money. When you take a distribution of $10,000 from either account, the total amount of taxable and non-taxable (basis) is considered to determine the ratio of taxation. Since the total of taxable funds is $75,000, and $25,000 non-taxable, $7,500 of the $10,000 distribution will be subject to tax, and $2,500 will be tax-free.An IRA Owner's Manual or if you'd prefer the Kindle version (and let's face it, ALL the cool kids do!), you can find that at this Kindle version link.