How can an adviser prove that a client has individual retirement account basis (after-tax funds) when it hasn’t been reported to the Internal Revenue Service?
If the IRA basis can’t be proved or reconstructed, then those after-tax IRA funds (the basis, which should come out tax-free), will be taxed when withdrawn, and this will result in a double tax on those assets. A recent case might provide some insight.
The U.S. Tax Court ruled that hardship distributions from a 401(k) and an IRA were taxable and subject to the 10% early distribution penalty. The court also allowed the IRA owner to claim a portion of his distribution as a tax-free return of basis, even though he had never reported his IRA basis to the IRS. (Gustavo E. Morles v. Commissioner, T.C. Summ. Op. 2015-13, Feb. 23, 2015)
Gustavo Morles was a faculty member of the University of Phoenix and participated in its 401(k) plan.
In 2010, he was unemployed and having financial trouble. Morles took distributions from both his 401(k) plan and IRA and used some of that money to pay his rent and avoid eviction.
He received a $6,893 distribution from his 401(k) plan in 2010. The plan distribution was reported to Morles and to the IRS on Form 1099-R, which showed the entire distribution amount as taxable (i.e., there were no after-tax funds).
He was younger than 59 1/2 at the time of the plan distribution.
PAYING THE RENT
Morles also had a small IRA that he used to pay his rent. His IRA was funded in 2008 with a $1,000 contribution, but he didn’t take a deduction for that contribution on his 2008 federal income tax return. Morles only had one IRA and never made another IRA contribution or took a distribution before he took a $951 early distribution in 2010. He received a Form 1099-R from the IRA custodian reporting the distribution.
Morles’ 2010 taxes were done by a paid tax preparer, but neither his 401(k) nor his IRA distribution was reported as income for the year. As a result, the IRS sent him a tax bill for the unreported income.
In a notice of deficiency dated April 2012, the IRS determined that Morles owed $4,789 as a result of his errors. He believed the distributions were tax- and penalty-free, and the issue wound up in Tax Court, where Morles represented himself.
He argued that neither distribution was taxable because he was suffering economic hardship, including the threat of eviction.
The court ruled that both distributions should be reported as income and that the 10% early distribution penalty applied. It determined that the 401(k) distribution was fully taxable because there were no after-tax funds in the plan.
The court also rejected Morles’ argument that hardship distributions from a company plan are tax-free because he provided no evidence that the tax code offers such treatment, probably because it doesn’t.
The IRS thought that the entire IRA distribution was taxable, because he had never completed a Form 8606 to report his nondeductible IRA contribution.
Morles, however, thought that it was tax-free because his IRA distribution was less than his initial $1,000 IRA contribution. In his mind, the IRA distribution was nothing more than a tax-free return of his investment.
The court allowed the IRA basis and ruled that the IRA distribution was partially taxable and partially tax-free under the pro-rata tax rule.
Although Morles didn’t properly report his nondeductible IRA contribution, the court said that he could prove that he had basis (after-tax funds) through other means. Furthermore, it indicated that there is nothing in the tax code that explicitly prevents an IRA owner from claiming basis that wasn’t initially reported correctly.
The court noted that Morles didn’t take a deduction for his IRA contribution at the time that it was made. Accordingly, his $1,000 contribution for 2008 was a nondeductible IRA contribution that created basis.
Although Morles only had one IRA that was funded solely by the $1,000 nondeductible contribution, it appears that his IRA had investment gains. Those gains are pretax funds, which are taxable and distributed ratably with his after-tax funds under the pro-rata formula.
Ultimately, the court ordered Morles and the IRS to redo their math and take into account the after-tax funds that were part of his $951 distribution.
The court agreed with the IRS that the 10% penalty applied to both distributions because he was younger than 59 1/2 at the time. Because Morles’ 401(k) distribution was fully taxable, the 10% penalty applied to that entire amount.
On the other hand, because the court ruled that his IRA distribution was partially tax-free, the 10% penalty only applied to the taxable portion of his distribution.
REPORTING AFTER-TAX AMOUNTS
When after-tax funds are contributed to an IRA, they must be reported on IRS Form 8606. By reporting such amounts, the IRS knows certain funds in the IRA have already been taxed and can’t be taxed a second time when they are later distributed.
After-tax funds can be added to an IRA in one of two ways: either via nondeductible IRA contributions or via rollovers of after-tax retirement funds that were held in an employer plan, such as a 401(k). Once inside an IRA, after-tax funds can generally only be withdrawn under the pro-rata rule, where each dollar withdrawn is partially taxable and partially tax-free, based on the percentage of after-tax money in the account.
If clients add after-tax money to their IRA during the year, they must file a Form 8606.
However, failing to timely file Form 8606 doesn’t automatically mean that a client will be unable to claim that a portion of the distribution consists of after-tax funds and thus is nontaxable. The client will just need to find a way to prove how much of the distribution, in fact, comprises after-tax funds.
One way to find any unreported nondeductible contributions is by checking IRA statements. Advisers may also be able to track down Form 5498 (IRA Contribution Information) for prior years, which would show if any IRA contributions were made.
Once an adviser figures out which years a client made contributions, look at the tax return for applicable years to see if a deduction was taken. If there is a year where an IRA contribution was made but no deduction was taken, it can be assumed that a nondeductible IRA contribution was made.
Note that nondeductible IRA contributions started in 1987, so there is no point in going back and scouring statements and returns before that.
Assuming that an adviser can prove prior basis, clients may want to file Form 8606 to bring it up to date. Clients should be sure to keep any supporting documentation in case the IRS questions the newly discovered basis.
Advisers can help clients avoid a double tax on IRA basis by checking to see if they made nondeductible IRA contributions and have reported them correctly.
Updating Form 8606 basis information is helpful for clients and their tax preparers, as well.
This story is part of a 30-30 series on preparing for retirement. This story was originally published on Oct. 1, 2015.