Ed Slott: How to Report Rollovers the Right Way

Christine Benz: You say another frequent place where people stub their toe relates to these backdoor Roth IRA contributions that people have been making in a piece of paperwork that needs to get filed along with the tax return to substantiate that the contribution consists of nondeductible dollars. Can you talk about that?

Ed Slott: It’s not only the backdoor Roth. Any IRA distribution where you have aftertax dollars in your IRA that come from generally making nondeductible contributions, you get credit for those. But you have to report them on Form 8606. And again, the tax programs are great on this. Again, garbage in, garbage out, if you put the info in. If you don’t put the info in, it’ll all show up as taxable, and you won’t keep track of your basis each year, your aftertax money. Because if you don’t take credit for that, in effect, you’re paying tax twice on the same money.

So make sure if you have aftertax funds and you take an IRA distribution, you file Form 8606, which keeps a cumulative record of all your nondeductible contributions. So when you pull anything out of an IRA, you’ll always have that percentage of what’s taxable and what’s tax-free. But you have to do things. You have to enter the input, which can be a little confusing. Again, even if you have the tax program, you have to look and make sure you put in the basis.

One of the questions on the 8606, “What’s your basis, and what’s your value of all your IRAs?” But how much accumulated basis? How much have you made in nondeductible IRA contributions? And that goes as well for inheritors because people inherit IRAs, and sometimes they didn’t realize their parents had nondeductible contributions. And when they take out the inherited IRAs, look back at the parents’ 8606 to get credit for those aftertax contributions, that’s almost always missed. Beneficiaries don’t usually think of that. They say, “Oh, here, I’m taking a distribution from my dad’s IRA, inherited IRA, it’s all taxable.” Maybe not if they made aftertax contributions.

Benz: Right. And it seems like pre-backdoor, those aftertax contributions were pretty popular. People would make those nondeductible IRA contributions.

Slott: Yes. So a lot of people have them, and you have to keep track of them on Form 8606 for your own benefit, to take credit for funds that were already taxed.

How to Report Rollovers the Right Way

Benz: You say that rollovers, if someone has done a rollover in a given year, that there can be snafus there, too.

Slott: Well, again, like with the QCD, you have to report it the right way. Now, most rollovers will be tax-free. That’s the whole point. You go from a 401(k) to an IRA or an IRA to another IRA, and a lot of them will be coded as rollovers, but you could miss it. People look, and they say gross amount, but the taxable amount may be zero. So you could roll over your $300,000 401(k) to your IRA. You’ll get a 1099. It should be coded rollover, but you have to watch it. Obviously, you should know that you don’t have tax on $300,000. That’s a tax-free rollover. Most rollovers are tax-free. So make sure that they are tax-free.

And some of the mistakes people make is because they didn’t do direct transfers. Always do direct transfers, never do the 60-day rollover. Sometimes you don’t get the money back in 60 days. Don’t do a take a check from a 401(k), like in my example, $300,000. If you don’t do a direct rollover to your IRA, you could have a tax because they take … Let’s do an easier example. Let’s say you have a $100,000 in your 401(k) and you want to roll it to your IRA, but you take a check made out personally to you, and you roll the money out, you’re not going to get a $100,000. You’ll only get $80,000 because if they make the check to you, by law, they’re required to take 20% withholding. So now you only have $80,000 to rollover if you have the other $20,000 laying around to make it up. But if you don’t, you could have a tax on the $20,000. That’s why you want to do direct rollovers and report them correctly on your tax return. You should generally have an idea. If you did a tax-free rollover, obviously there should be no tax, but the IRS won’t know that. They might if the coding is right. But you could actually undo that by not showing it yourself as tax-free.