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Turns Out You CAN Be A Little Bit Pregnant

surprise by PinkMoose 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 would 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 – meaning that you can’t take out just some of the coffee, 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 have made after-tax contributions to your IRA, you are 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:  for example, 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 – and money taken out of the account(s) comes out ratably.  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; and 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 and 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) plan – but ONLY the taxable portion, 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.  And 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.

Photo by PinkMoose

5 Comments

  1. […] 401(k) plan can help you to “separate” the deductible IRA assets from the non-deducted. See this article about the pro rata distribution rule for more information. Essentially this benefit gives you a way to bypass the “little bit […]

  2. […] separate traditional IRA, the conversion of your post-tax money will be partly taxed due to the cream-in-the-coffee rule, which requires that all IRAs be considered as one with regard to distributions (including Roth […]

  3. […] you happen to have another IRA (or IRAs) that are deductible in nature, you will have to apply the pro rata tax rules to the […]

  4. […] 401(k) plan can help you to “separate” the deductible IRA assets from the non-deducted.  See this article for more information.  Essentially this benefit gives you a way to bypass the “little bit […]

  5. […] non-deducted, after-tax contributions.  Plus this must be the only IRA that you have – see the this post for the “Turns Out You CAN Be A Little Bit Pregnant” rule.  There’s also a way […]

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