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Updated July 14, 2024 Reviewed by Reviewed by Ebony HowardEbony Howard is a certified public accountant and a QuickBooks ProAdvisor tax expert. She has been in the accounting, audit, and tax profession for more than 13 years, working with individuals and a variety of companies in the health care, banking, and accounting industries.
There are benefits to taking after-tax distributions from a retirement account. If you follow specific rules, the amount withdrawn will be free of taxes and penalties.
Most retirement plan participants use pretax assets to fund their employer-sponsored plans, such as 401(k) and 403(b) qualified accounts, or they claim a tax deduction for amounts contributed to their traditional individual retirement accounts (IRAs). In both cases, these contributions can help to reduce the individual’s taxable income for the year to which the contribution applies.
However, it is also possible to contribute amounts to employer-sponsored plans on an after-tax basis, and contributions can be non-deductible for IRAs. The advantage of accumulating after-tax assets in a retirement account is that when they are distributed, the amounts will be tax and penalty-free. However, this benefit is realized only if the necessary steps are taken.
Reaping the benefits of this strategy starts with good recordkeeping and clear communication with your plan administrator and the Internal Revenue Service (IRS). Today, several free (and fee-based) software tools are available to help you keep track of your taxable and tax-deferred investments and income flows. An accountant can also help you make sure you have all your ducks in a row.
The administrator for your qualified retirement plan is responsible for keeping track of which portion of your balance is attributed to after-tax assets and which portion of your balance is attributed to pretax assets. However, it helps if you check your statements periodically to ensure that the tabulations match what you think they should be. This will allow you to clarify possible discrepancies with the plan administrator.
Your IRA custodian is not required to keep track of the after-tax balance in your IRA, and most do not. As the owner of the IRA, you are responsible for keeping track of such balances, and this can be accomplished by filing IRS Form 8606.
Make sure you read the filing instructions that accompany Form 8606, as they provide details on the sections of the form that must be completed.
If you make a nondeductible contribution to your traditional IRA or roll over after-tax assets from your qualified plan account to your IRA, you must file IRS Form 8606 for the year the amount is contributed to the IRA. While the IRS does not currently require Form 8606 to be filed for rollover of after-tax amounts, it may be a good idea to record such amounts for your records.
Form 8606 lets the IRS know that the amount represents after-tax assets, and it helps you keep track of the balance of your IRA that should be tax-free when distributed. Form 8606 must also be filed for any year in which distributions occur from any of your traditional, SEP, or SIMPLE IRAs and you have accumulated after-tax amounts in any of these accounts.
Generally, your plan administrator will indicate the taxable portion of amounts distributed from your qualified plan account on the Form 1099-R that you receive for the year. If the amount is not properly indicated on the 1099-R, you may want to request written confirmation from the plan administrator of the portion of the distribution that is attributable to after-tax assets. This will help ensure you include the correct amount in your taxable income for the year.
With the exception of “return of excess contributions,” your IRA custodian is not required to make a distinction between the taxable and nontaxable portion of amounts distributed from your traditional IRA. You must provide that information on your income tax return by indicating the entire amount of the distribution versus the amount that is taxable.
For more information, see the instructions for line 4a on page 1 of IRS Form 1040. Form 8606 will help you determine the taxable and nontaxable portions of amounts distributed from your traditional IRA.
All of your IRA accounts are treated as a single one when taking distributions, meaning that the after-tax and pretax amounts in them must be pro-rated across all of the accounts.
If your qualified plan or traditional IRA includes after-tax amounts, distributions usually include a pro-rata amount of your pretax and after-tax balance. For this purpose, all of your traditional, SEP, and SIMPLE IRAs are treated as one account.
For instance, assume that you made an average of $20,000 in after-tax contributions to your traditional IRA over the years, and your traditional IRA also includes pretax assets of $180,000, attributed to rollover of pretax assets and deductible contributions. Distributions from your IRA will include a pro-rata amount of pretax and after-tax assets. Let’s look at an example using these numbers.
Jamie has several IRAs, which consist of the following balances:
Jamie withdraws $20,000 from IRA No. 1. They must include $18,000 as taxable income from the $20,000 they withdrew. This is because all of Jamie’s traditional, SEP, and SIMPLE IRAs are treated as one IRA for the purposes of determining the tax treatment of distributions when Jamie has a basis (after-tax assets) in any of their traditional, SEP, or SIMPLE IRAs.
The following formula can be used to determine the amount of a distribution that will be treated as non-taxable:
Basis ÷ Account Balance x Distribution Amount = Amount Not Subject to Tax
Using the figures in the example above, the formula would work as follows:
$20,000 ÷ $200,000 x $20,000 = $2,000
As IRS Form 8606 includes a built-in formula to determine the taxable amount of distributions from your traditional IRAs, you may not need to use this formula for distributions from your IRA.
For qualified plan accounts that include a balance of after-tax amounts, distributions are usually pro-rated to include amounts from pretax and after-tax balances. This means that, similar to IRAs, you can’t choose to distribute only your after-tax balance.
However, certain exceptions apply. For instance, if your account includes after-tax balances accrued before 1986, these amounts may be distributed in full, resulting in the entire amount being non-taxable, rather than being pro-rated.
If your retirement account balance includes after-tax amounts, whether these amounts can be rolled over depends on the type of plan to which the rollover is being made.
The following is a summary of the rollover rules for these amounts:
You might choose to make after-tax contributions due to their tax-deferred status, which allows you to delay paying taxes on earnings in the account. The reason why this deferral saves money is that, theoretically, the income tax bracket you will be in when you withdraw funds from the account (typically in retirement) will be lower than the income tax bracket you are in when you make the after-tax contributions.
No. Both after-tax contributions and Roth contributions are paid with after-tax money, and they don't reduce your taxable income in the year you make the contribution, as is the case with a traditional retirement account.
However, when you withdraw funds from a Roth account, as long as you've had the account for five years, it's tax-free. That's not the case with after-tax contributions: when withdrawing funds, you'll need to pay taxes.
The main benefit of an after-tax contribution is that the earnings grow tax-deferred. This means that you won't pay taxes on the earnings until you withdraw funds, typically in retirement, when you might be in a lower income tax bracket than you are when you make the contribution.
Bear in mind that this is just an overview of the rules that apply to your after-tax balance in your retirement account. Having a thorough understanding of the rules will ensure that you include the right amount in your taxable income for the year you receive a distribution from your retirement account and not pay taxes on amounts that should be tax-free.
Consider consulting a tax professional for assistance to make sure your after-tax assets are treated correctly on your tax return, and you know which tax forms to file each year.
