8.9 Partially Tax-Free Traditional IRA Distributions Allocable to Nondeductible Contributions

If you ever made a nondeductible contribution to a traditional IRA, you must file Form 8606 to report a 2012 distribution from any of your traditional IRAs, even if the distribution is from an IRA to which only nondeductible contributions were made. All of your traditional IRAs are treated as one contract. If you receive distributions from more than one IRA in the same year, they are combined for reporting purposes on Form 8606. When you withdraw an amount from any traditional IRA during a taxable year and you previously made both deductible and nondeductible IRA contributions, the part of your withdrawal that is allocable to your nondeductible contributions is tax-free; any balance is taxable. You may not claim that you are withdrawing only your tax-free contributions, even if your withdrawal is less than your nondeductible contributions. The six steps below reflect the IRS method used on Form 8606 to figure the nontaxable and taxable portions of the IRA distributions.

The rule requiring you to combine nondeductible and deductible IRAs when making IRA withdrawals does not apply to withdrawals from a Roth IRA. A Roth IRA is treated separately. After a five-year period, withdrawals after age 59½ from a Roth IRA are completely tax-free (8.23).

A bank or other payer of a distribution from a traditional IRA will not indicate on Form 1099-R whether any part of a distribution is a tax-free return of basis allocable to nondeductible contributions. It is up to you to keep records that show the nondeductible contributions you have made. IRS instructions require you to keep copies of all Forms 8606 on which nondeductible contributions have been designated, as well as copies of (1) your tax returns for years you made nondeductible contributions to traditional IRAs; (2) Forms 5498 showing all IRA contributions and showing the value of your IRAs for each year you received a distribution; and (3) Form 1099-R (or previously used Form W-2P) showing IRA distributions. According to the IRS, you should keep such records until you have withdrawn all IRA funds.

Figuring the taxable portion of a traditional IRA distribution.

If you received a distribution from a traditional IRA in 2011 and have ever made nondeductible contributions to any of your traditional IRAs, follow Steps 1–6 to determine the tax-free and taxable portions of the 2012 distribution. These steps assume that you did not convert a traditional IRA to a Roth IRA during 2012. If you did convert a traditional IRA to a Roth IRA, follow the instructions to Form 8606.

Step 1. Total IRA withdrawals during 2012.
Step 2. Total nondeductible contributions to all IRAs made by the end of 2012. Tax-free withdrawals of nondeductible contributions in prior years reduce the total. If you made any contributions to traditional IRAs for 2012 (including a contribution made between January 1 and April 15, 2013) that may be partly nondeductible because your modified adjusted gross income is within the deduction phaseout range shown in 8.4 for active plan participants, you should include the contributions in the Step 2 total.
Step 3. Add Step 1 to the value of all your IRAs (include SIMPLE IRAs and SEP IRAs) as of the end of 2012. If you received an IRA distribution within the last 60 days of 2012 that was rolled over to another IRA within the 60-day rollover period (8.10) but not until 2013, add the 2013 rollover to the year-end balance.
Step 4. Divide Step 2 by Step 3. This is the tax-free percentage of your IRA withdrawal.
Step 5. Multiply the Step 4 percentage by Step 1. This amount is tax free.
Step 6. Subtract Step 5 from Step 1. This amount must be reported as a taxable IRA distribution on your 2012 return.
EXAMPLE
On November 16, 2012, Nick James withdraws $5,000 from his traditional IRA, having made deductible IRA contributions of $8,000 and nondeductible contributions of $6,000 as follows:
Year Deductible Nondeductible
1991 $2,000          0
1992   2,000          0
1993   2,000          0
1994   1,000 $1,000
1995   1,000   1,000
1996          0   2,000
1997          0   2,000
$8,000 $6,000
Assume that on December 31, 2012, Nick’s total IRA account balance, including earnings, is $27,500, and that the November withdrawal was his first IRA withdrawal. On Form 8606 for 2012, Nick figures that $923 of the $5,000 IRA withdrawal is tax free and $4,077 is taxable.
Step 1. IRA withdrawal in November 2012 $5,000
Step 2. Nondeductible contributions for all years   6,000
Step 3. IRA balance at end of 2012 ($27,500) plus Step 1 32,500
Step 4. Tax-free percentage: $6,000 (Step 2) ÷ $32,500 (Step 3) 18.46%
Step 5. Tax-free withdrawal: 18.46% (Step 4) × $5,000 (Step 1)       923
Step 6. Taxable withdrawal: $5,000 (Step 1) − $923 (Step 5)  $4,077
The total $5,000 withdrawal should be reported on Line 15a of Form 1040 or on Line 11a of Form 1040A, and the taxable $4,077 portion should be entered on Line 15b (Form 1040) or on Line 11b (Form 1040A).

Deductible IRA loss based on unrecovered nondeductible contributions.

According to the IRS, a loss is allowed if all IRA funds have been distributed and you have not recovered your basis in nondeductible contributions. However, the loss must be claimed as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income floor on Schedule A, Form 1040.

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image Planning Reminder
Deducting Loss
A loss on an IRA investment is deductible only if your basis in nondeductible contributions has not been received after the entire account has been distributed.
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EXAMPLE
Paula Brown made nondeductible IRA contributions of $10,000 from 1994–1998. In 2011, she withdrew $6,000. The 2011 year-end balance was $8,000. The tax-free portion of the withdrawal was $4,286 ($10,000 nondeductible contributions ÷ $14,000 total of withdrawal plus year-end balance × $6,000 withdrawal).
After the 2011 withdrawal, her basis is $5,714 ($10,000 − $4,286). Because of stock market losses, the value of the IRA falls to $3,000 by the end of 2012. If she withdraws the entire $3,000 balance before the end of the year, she can claim a $2,714 loss ($5,714 basis − $3,000 distribution) for 2012 but only as a miscellaneous itemized deduction subject to the 2% floor (19.1) on Schedule A of Form 1040. Depending on her 2012 adjusted gross income and other miscellaneous itemized deductions, Paula may be unable to claim the loss on her IRA because of the 2% floor. If the loss is allowed on Schedule A, it must be added back to income for purposes of figuring whether Paula is subject to alternative minimum tax (23.2).
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