An audit of Susan’s IRA transactions showed she had paid $50,000 in income tax, despite being eligible for a tax exemption. She thought her IRA custodian would inform her about the taxable and non-taxable portions of her distributions, but that assumption was incorrect. As someone managing her IRA, it was her duty to understand how much of her withdrawal would be tax-free. Below is a look at how this mistake happened and the steps taken to fix it.
Why Does $50,000 Qualify for Tax-Free Status?
By 2024, Susan’s traditional IRA had a total balance of $1 million. This amount included:
- $900,000 comprised of the usual tax-deductible contributions made before taxes and gains from her traditional IRA.
- $40,000 in contributions that were post-tax and non-refundable.
- $60,000 from a rollover of her prior 401(k).
This breakdown resulted in her IRA being about 90% pre-tax and 10% post-tax. The $900,000 from pre-tax funds meant those amounts would be taxable upon distribution.
Since $100,000 originated from already taxed amounts, that portion is considered tax-free.
In 2024, Susan withdrew $500,000 from her IRA.
Tax Insights
According to proportional distribution rules for IRAs, the $500,000 withdrawal included both pre-tax and post-tax amounts—specifically, $450,000 that would be taxable and $50,000 that could be exempted. However, Susan mistakenly reported the entire $500,000 as taxable on her tax return.
What Went Wrong
One significant error was that Susan did not file IRS Form 8606.
When she made her contribution, she noted “non-deductible” in the memo line to her IRA custodian. Additionally, when she rolled her 401(k) into a traditional IRA, she sent a statement to verify the tax statuses of those funds.
She incorrectly thought the custodian would keep track of how much was post-tax and inform her of both taxable and non-taxable amounts, similar to what her 401(k) administrator did.
However, IRA custodians do not monitor post-tax amounts and are not required to. The onus is on the account owner. Consequently, her custodian flagged the full $500,000 as taxable.
Planning Tips
When reporting distributions from traditional IRAs, custodians will usually highlight all amounts in Box 1 and the taxable amount in Box 2A on Form 1099-R. However, it’s crucial to check Box 2B, which might be left unchecked if the tax amount is undetermined, allowing you to adjust your tax return if necessary.
As someone self-managing her investment, Susan made a mistake by inaccurately reporting her tax status concerning Box 2A of Form 1099-R. She thought she could count all remaining amounts from her IRA as tax-free in the future.
Her memo to the custodian? That turned out to be meaningless.
What she needed was to file IRS Form 8606 to accurately report her IRA’s balance and non-deductible contributions.
- Each year, report non-deductible contributions.
- Detail distributions, including any remaining amounts.
- Account for all conversions, including tax amounts.
Similar to Susan’s case, if Form 8606 isn’t filed when necessary, you might end up overpaying taxes.
Correcting the Mistake
Luckily, Susan could easily rectify her lack of filing Form 8606 for her non-deductible contributions. She collaborated with her CPA to:
- File Form 8606 to reflect her modest contributions each year.
- File Form 8606 for 2024 to ensure $500,000 distributions were broken down accurately.
- Revise her 2024 tax return, allowing the $50,000 to be properly classified as tax-free.
Filing Tips
Always use the correct version of Form 8606 for the year of the activity. For instance, if Susan made a $5,000 non-deductible IRA contribution in 2020, her CPA needed to file Form 8606 for that year, even if it was submitted later in 2025.
Lessons from Susan’s Case
To avoid similar mistakes with your IRA, consider these tips:
Document and Track Contributions
Contributions to a traditional IRA can either be tax-deductible or non-deductible. Use tax returns alongside IRA deduction worksheets Form 1040 instructions to determine your deductibility.
Deductible contributions will be reported on line 20 of your tax return. If you can’t claim a deduction, then make sure to submit Form 8606 to report your non-deductible contributions.
Understand IRA Distributions
Distributions from traditional IRAs are generally treated as ordinary income. However, if part of your IRA consists of post-tax amounts, those portions are not taxed upon withdrawal. You can’t choose to withdraw only non-taxable funds, as distributions must reflect a proportional mix from both pre-tax and post-tax balances across all traditional IRAs.
Note: The Roth conversion is included in this calculation.
If your IRA has a remaining balance and you convert it to a Roth, you will need to file Form 8606.
Keep Detailed Records
Neglecting to track your contributions could result in unintended taxes on amounts that should be tax-exempt.
To avoid this, maintain detailed records of:
- All IRA contributions.
- Rollover details from employer plans, especially regarding post-tax amounts.
- Form 5498 that reflects contributions made to the IRA.
- Form 1099-R that details all distributions from traditional IRAs.
- Your tax return records.
If you’re uncertain whether your IRA has a remaining balance, consult with your CPA. Making sure you have access to these documents can help identify missed opportunities and correct tax errors.
Moving Forward for Susan
If Susan finds that her future contributions to a traditional IRA cannot be deducted, she might want to consider contributing to a Roth IRA. If she isn’t eligible to contribute regularly to a Roth IRA, consulting a tax advisor about using a backdoor Roth IRA strategy might be worthwhile to manage her remaining balance effectively.
