Cutter Family Finances: The Facts About IRA Distributions
By: Jeffrey Cutter, January 8, 2014
If there were a fact or missing piece of information that could cost you thousands, when would you want to know about it, before or after you made a financial decision? I am being a bit flip here but let me tell you about a call I received last week from a gentleman (let’s call him Ben) from Sandwich. Apparently a client of mine and Ben are neighbors and they were discussing financial strategies over a “little” eggnog on Christmas Eve. My client thought that there was something “not right” with Ben’s story, so he suggested Ben talk to me.
This is what Ben told me. He is 58 and changed jobs about five years ago. After Ben’s separation from his old employer, he rolled over his 401(k), which consisted of both pre-tax and after-tax contributions, to a traditional IRA. I am good with this so far. After rolling over his 401(k) to a traditional IRA, this past year Ben helped one of his sons buy his first house and gave him $50K toward his down payment. Ben’s current advisor suggested he withdraw the $50K from his Traditional IRA. His rationale was that since Ben had contributed more than $50K in after-tax dollars to his 401(k), he had effectively already paid taxes on the amount he intended to withdraw, so it would not be subject to additional tax.
Hmmm . . . not so fast, Ben. We have a problem.
When after-tax funds are held within a 401(k) plan, the plan administrator often agrees to keep a separate accounting of both the pretax and after-tax contributions, as well as all income earned on those funds. However the IRS does not require a separate accounting of after-tax funds rolled into an IRA. Instead, in the year of rollover, IRS Form 8606 “Nondeductible IRAs” is filed with an individual’s personal income tax return. Form 8606 reports the amount of after-tax funds included in a rollover. The challenge with rolling over after-tax money to an IRA is that you simply cannot withdraw the after-tax contributions tax-free from an IRA. The after-tax contributions get treated as nondeductible contributions under what is known as the pro rata rule.
Pursuant to the pro rata rule, all distributions from an IRA represent a “proportionate share” of both pretax and after-tax contributions. That percentage is calculated by dividing the amount of after-tax contributions by the balance of all of an individual’s IRAs, including SEP and SIMPLE IRAs.
The best way I could think of to help Ben understand this concept was to use his eggnog as an analogy. The eggnog is his IRA, and the brandy is the after-tax money rolled into his IRA (what’s eggnog without a little brandy?). Once you mix the brandy with the eggnog, you cannot separate the two. In other words, you cannot avoid tax by just withdrawing the after-tax funds. Every drop has a percentage of both eggnog and brandy. The only way Ben can change that percentage is to either add more eggnog or add more brandy.
So Ben has $500K in his IRA, 10 percent of which has already been taxed. The IRS won’t let Ben withdraw the full 50k for his son’s down payment completely tax-free. The way the IRS looks at Ben’s IRA, it’s like the eggnog (one part tax-free, nine parts taxable...) and we know how Uncle Sam likes his eggnog . . . with as much brandy (tax) as possible.
So Ben cannot withdraw his 50k completely tax-free because of the IRS’s pro rata rule. However the IRS does allow him to take 10 percent ($5,000) of his withdrawal tax-free, and the rest would be subject to ordinary taxes for federal and state purposes.
Now, you’d think that Uncle Sam was done mixing his eggnog (one part brandy, nine parts eggnog,) but we both know that Uncle Sam loves his eggnog . . . so he goes for the extra helping. Since Ben is under the age of 59 1/2 at the time of distribution, he must pay a 10 percent tax penalty on his withdrawal. In essence, Ben could be paying in upward of 40 percent on his 45K distribution to Uncle Sam . . . and he is not even his real uncle!
While this is not what Ben wanted to hear, at least he now understands the tax consequences, the facts, and the right information regarding withdrawing money from his IRA. Knowing what Ben knows now, when do you think Ben would have liked to learn about the pro rata rule, before or after he made his financial decision? Of course . . . before.
Folks, retirement saving and distribution planning are extremely complicated. I find that many times, good, solid, hard-working, well-intentioned investors make important financial decisions without understanding all of the consequences of their choices. Cutter Family Finance readers, make it one of your goals in this New Year to educate yourself before making any important financial decisions.
In 2014, make it your year to be vigilant and stay alert, because you deserve more. Happy New Year!
Jeffrey Cutter, CPA, PFS is the managing partner from Cutter Financial Group, LLC (www.cutterfinancialgroup.com) which provides private wealth and investment management.
Investment advice is offered by Horter Investment Management, LLC, a registered investment adviser. Insurance and annuity products are sold separately through Cutter Financial. Securities transactions for Horter Investment Management clients are placed through Pershing Advisor Solutions, Trust Company of America, Jefferson National Monument Advisor, Fidelity, Security Benefit Life and FC Stone. 1. http://tinyurl.com/nwvbep4