Turns Out You CAN Be A Little Bit Pregnant

Photo credit: jb

Remember back in junior high (or whenever it was) during health class (or sex ed, or whatever they called it for you) – how it was explained that pregnancy is a black or white thing: “nobody gets just a little bit pregnant” was the story my health teacher gave us to remember. As it turns out, there are many other absolutes in life that are similar. However, in a totally characteristic move, the IRS gives us a way that takes something that you think would be absolute, and twists it so that you can, in fact, be a little bit pregnant (or rather, a little bit taxable, a little bit tax free, in this case).

Confused yet? Sorry, that wasn’t my intent… some people refer to this as the “cream in the coffee” rule. With this analogy, it is explained that once you put cream in your coffee, you can’t take out just some of the coffee or just cream, you have to take out both cream and coffee. Oh bother, with the analogies! Let’s get into this.

IRA Funds – Part Taxable, Part Tax-Free

If you’ve made after-tax contributions to your traditional (non-Roth) IRA, you’re likely expecting that at some point you can take those contributions out again, tax free. And you’re right to expect that, because that’s exactly what you can do. However (and there’s always a however in life, right?), if the after-tax money you have in your IRA isn’t the only money in ALL of your IRAs, any money that you take out will be partly taxable and partly tax-free. (this was where the “little bit pregnant” thing comes in)

Here’s how it works: Let’s say you have two IRAs, each worth $5,000. One is a traditional deducted (pre-tax) IRA, and the other is a traditional non-deducted (after-tax) IRA. If you wanted to take $100 out of either account, the IRS considers all of your IRAs as one account. Any money taken out of either account is considered pro rata, partly taxable and partly non-taxable. So in the $100 that you take out, $50 will be tax-free, and $50 will be taxed.

Let’s do another example, a little more real world:  You have two IRAs, one worth $5,000, which is made up exclusively of a $3,000 deducted contribution and $2,000 worth of growth and interest; the second is made up of a $4,000 deducted contribution, a $5,000 non-deducted contribution, and $1,000 worth of growth and interest, for a total of $10,000. You would like to take a distribution of $1,500 from one of the accounts. In the IRS’ eyes, you are taking out $500 which is non-taxed, and $1,000 which will be taxed. This is because, out of the total of $15,000 in the two accounts, only $5,000 was “after tax” funds. Everything else, the growth, interest and the deductible contributions, is considered taxable.

How To Get Around It (or How You Can NOT Be A Little Bit Pregnant)

Don’t lose faith, though, there is one way around this dilemma. The IRS allows you to roll over funds from your IRA into a Qualified Retirement Plan (QRP) such as a 401(k) – but ONLY the taxable portion may be rolled over to the QRP. If there are commingled funds in your account(s). So, in this case, the IRS goes along with the absolute (go figger – they treat the same money two different ways!) and requires that no after-tax contributions be rolled over into the QRP.

So, if you have a 401(k) plan at work, or an existing 401(k) that you haven’t rolled over into an IRA, you can use this account to split out your taxable IRA money from the non-taxable IRA money. Then you could do a tax-free conversion of the non-taxed IRA money into a Roth IRA if you wished, for example, as long as you fit all the other criteria.

Going back to our example above, you would rollover to your 401(k) plan the $10,000 from the two IRAs that represent the deductible contributions plus the growth and interest. This leaves you with $5,000 in non-deductible contributions from the one IRA. You could take a withdrawal as you had planned at this point, with no tax or penalty.

In addition, since your only IRA now only holds non-deductible contributions (no growth or deductible contributions), you could convert the IRA to a Roth IRA – also with no tax or penalty. This is a strategy that many have used to separate the cream from the coffee to make the Roth conversion painlessly.