Tax Saving Tips for IRA Investors – After Tax Contributions (Basis), Income in Respect of Descendent, 10% Excess Tax & Substantially Equal Periodic Payments (SEPPs)

tax-dayThousands of IRA investors miss out on important tax benefits each year because they are not familiar with the Tax Act and laws. Others make crucial errors when filing their tax returns. For instance, IRA investors may pay taxes on monies that should have been tax free or pay excise taxes on IRA distributions when these distributions should be free of tax. Our aim in this article is to highlight some IRA tax laws and how you can benefit from them.

ii) Track Basis to Avoid Getting Double Taxed

After-tax IRA balances (also known as ‘basis’) grow in Individual Retirement Accounts (IRAs) from non deductible contributions and IRA rollovers of after-tax amounts. By saying non deductible contributions, we mean you pay taxes on all your earnings now, and will not be taxed when you withdraw them upon retirement, at 65. This is how a Roth IRA works. It is essential we clarify this point, so read this example below:

After-Tax Contributions?

Consider Jackson who earns a $65,000 annual salary. Jackson is currently in the 25% tax bracket and contributes $3500 a month to his Roth IRA. Jackson would therefore pay income taxes of $3500 x 25% = $875 and would contribute $3500 – $875 = $2625 to his Roth IRA. If Jackson expects to be in a 33% tax bracket upon retirement, he will have to pay $3500 x 33% = $1155 upon his retirement. Therefore by making after-tax Roth IRA contributions now and getting taxed at the lower 25%, Jackson avoids having to pay taxes @ 33% when he hits retirement.

Distributions of after-tax balances (basis) is supposed to be tax-free. However, if you fail to keep track of these amounts that you have contributed, any distributions you take will result in you having to pay taxes to the IRS resulting in double taxation. Also, if you do not file IRS Form 8606 (Nondeductible IRAs) to the IRS, you will owe them a penalty of $50 unless you show a valid reason why you didn’t file that form. Consider this example.


John made a rollover contribution of $50,000 from his 401k plan to a Traditional IRA out of which $15,000 was contributed on an after-tax basis. This means distributions of this $15,000 should be tax free because John already paid taxes on them. John, busy as he is, failed to file Form 8606 to the IRS and did not keep track of the amount. John withdrew his entire $50,000 balance from his IRA due to some emergency and included the entire amount as taxable income. This means John paid taxes on his $15,000 contributions that should have been tax-free. Had John filed IRS Form 8606 in the year the rollover occured, he would not have got double taxed on the $15,000 distribution.

Once you make a nondeductible contribution to a Traditional IRA or rollover after-tax amounts, any distributions taken from the IRA will include a prorated amount of pre-tax and post-tax assets. These assets will be broken down into pre-tax and post-tax amounts just like how John has $35,000 pre-tax assets and $15,000 of post-tax assets in his Traditional IRA. Another important point to remember is that if you have multiple traditional, SEP or Simple IRAs with different beneficiaries, you might want to maintain a separate Form 8606 for each type of IRA. Then, each beneficiary will be able to determine their basis (after-tax balances) in their inherited IRAs and file any IRS Form 8606.

Income in Respect of Decedent

Pre-tax IRA assets or balances that are not distributed before the IRA investor’s death are not taxable to the deceased IRA owner. Instead, they will be added to taxable income of the beneficiary for current tax year. However, these assets may be included in the deceased IRA investor’s estate and subject to estate tax. However, if the deceased IRA owner filed IRS Form 706 (United States Estate and Generation-Skipping Transfer form), the beneficiary might be eligible for a federal tax deduction for the total amount of estate taxes listed on form 706. This deduction is known as Income in Respect of Decedent (IRD) and is one of the most important deductions that a beneficiary could get with inherited assets or monies. Unfortunately, it is a deduction least aware of by IRA investors and owners.

Tax experts estimate that failure to claim the Income in Respect of Decedent (IRD) deduction can result in a tax rate of 80% or more on the inherited amount, broken down to a combination of estate taxes paid by the deceased IRA owner and federal/local state taxes paid by the beneficiary who inherits the assets after the death of the IRA owner. Income in Respect of Decedent (IRD) is claimed as an itemized tax deduction on IRS Schedule A and is not subject to the 2% of modified adjusted gross income (MAGI) limit that applies to miscellaneous deductions. If you don’t itemize your IRD deduction, your deduction will not be valid.

Exceptions to the 10% Early Withdrawal Penalty

Any distributions taken from your IRA before you reach the age of 59 and 1/2 are subject to a 10% early withdrawal penalty, unless you meet 1 of the following requirements:

– the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
– the Roth IRA investor becomes disabled at the time of taking the distributions
– the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
– the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or qualified family member. This is limited to $10,000 per person per lifetime. Qualified family members include:
–> the Roth IRA investor
–> the Roth IRA investor’s spouse
–> children of the Roth IRA investor
–> grandchildren of the Roth IRA investor
–> parent or ancestor of the Roth IRA investor

Your IRA administrator will inform you that one of these exceptions applies to your distribution and that you won’t be taxed the 10% on it. This is usually done by checking Box 7 of IRS Form 1099-R. Your IRA administrator however may not check Box 7 on IRS Form 1099-R if any of these criteria apply:

– You did not indicate on your distribution request that an exception applied to the distribution
– An error was made in processing your distribution

If you are eligible for any of the above exceptions and this is not indicated on your Form 1099-R, you may correct this by filling out IRS Form 5329.

How to Waive the 10% Excess Tax

Certain distributions must be completed by end of the year in order to avoid the 10% excess tax. Example when you reach 70 and 1/2 years old, you can defer the minimum required distributions (MRDs) until April 1st of the following year. Any other year apart from the year when you hit 70 and 1/2 years old, your minimum distribution CANNOT be deferred until April 1st of the following year; infact they must be completed by end of that year. If you don’t do this, you will owe the IRS a 50% excess accumulation penalty on the distribution. If you have a valid reason to say you were not able to complete your distribution by year end, write a letter to the IRS to waive the penalty; ofcourse your excuse must be reasonable.

Substantially Equal Periodic Payments (SEPPs)

Another way to avoid the 10% excess tax is to take your distributions in the form of as substantially equal periodic payments (SEPPs). You must take the period payment by end of the year or else your SEPP will become void. An SEPP becoming void means you will have to pay excise taxes on all your distributions + interest charges. Your only way out of this trouble is to set up a new SEPP or provide a legitimate reason for your shortfall to the IRS in the form of an apology letter.

Filing Your Taxes

If you got double taxed or missed out on some important deductions on your tax return, the IRS allows you to submit an amended tax return (IRS Form 1040X) for upto 3 years after the filing of the tax return or 2 years after the date where the individual pays any taxes for that year, whichever is later. To make it easier, be sure to submit your initial IRS Form 8606 together with the IRS Form 1040x.