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Isolating After-Tax Basis in an IRA

Isolating After-Tax Basis in an IRA

| October 10, 2021

On September 13, 2021, the House Ways and Means Committee proposed major tax law changes. The legislation offers a glimpse into what the tax code might look like come January 1, 2022. By now, I’m sure you have heard about the highlights—rate increases for individuals and couples with income above a certain level, changes to the capital gains tax rates, estate tax implications, and more.

At ISC, we have been studying the bill in-depth. We called upon our partners in the tax and estate planning world to help us identify potential financial planning opportunities that exist today and in the future. We are preparing now for all of the possible scenarios.

One thing is almost certainly going away next year—the backdoor Roth IRA. The issue is time-sensitive and you must act by December 31. Congress and the IRS are cracking down on this generous strategy in which an individual converts after-tax basis in an IRA or 401(k) to a Roth account. We will miss the tax-advantaged savings strategy.

While it is uncommon, an individual can have an after-tax basis in an IRA or 401(k). It usually happens when someone makes a contribution to an IRA and is over the Modified Adjusted Gross Income (MAGI) limit. The individual is not allowed to deduct the contribution from their income on their tax return.

Diving deeper, when an IRA distribution is made, the IRS determines if the distribution is subject to aggregation and pro-rata rules. Regardless of the number of IRAs, if there is a mixed composition of after-tax, pre-tax, and earnings, a distribution from any IRA is made on a pro-rata basis. This is the aggregation rule. The downside for the taxpayer is that pro-rata distributions from non-taxable basis and taxable earnings or pre-tax contributions result in ugly partially taxable distributions or conversions.

The upshot: Suppose we were able to isolate the basis. By doing so, we shelter pre-tax contributions and earnings so that they are not subject to the aggregation and pro-rata rules. Once that piece is sheltered, we can cleanly distribute or convert it to a Roth account without incurring taxes. Then we are on the gravy train—future earnings on the account would be tax-free when distributed in retirement or by heirs!

What feels like a small win today compounds over the decades to be a very significant tax savings.

Next steps? The best way to determine if you have an after-tax basis in an IRA is to 1) ask your tax preparer or 2) search past tax returns for form 8606.

We must emphasize, the conversion of the basis will not be allowed if the current tax proposal passes without modifications. ISC Advisors will closely watch for changes to the bill so our clients stay a step ahead. Please reach out to our team with any questions. The tax time bomb is ticking—we can investigate if this tax-savvy strategy can benefit you and your family.