I am 43 years old. I know withdrawals from a Roth IRA, if taken after I turn 59 1/2 , are tax free. But I still receive a lot of Roth IRA statements and other papers in the mail. Which papers should I save and why?
- F.C., Orlando
Look at the basic checklist below:
End-of-year statements for Roth IRAs, which should list each investment made during the course of a year.
Form 5498, which you're likely to receive in the mail every May.
Form 8606, which might be attached to some federal tax returns you've filed in previous years.
Form 8606 keeps track of "nondeductible IRAs." Part III of Form 8606 - lines 19 through 25 - might contain valuable information about the history of your Roth IRA.
See if you can find any or all of these aforementioned documents in a desk drawer or filing cabinet around your home. Ask your accountant, bank, mutual fund company or brokerage house to provide duplicates of these documents, if you have trouble finding them.
These documents matter - and here's why.
"They can help you document a cost basis in a Roth IRA," said Rebecca Cohen, a spokeswoman for Vanguard Group, a mutual fund company. Having the means to document cost basis can lower your taxable income if, or when, you're forced to withdraw money from a Roth IRA before you reach age 59 1/2 - perhaps to raise cash in an emergency.
Example: You withdrew $10,000 from a Roth IRA in 2003. The Roth IRA was worth $50,000 at the end of 2002. From your records, you know your basis in that Roth IRA is $20,000.
"The higher your basis, the smaller portion of that withdrawal will be subject to taxes and penalties," said Dianne Besunder, a spokeswoman for the IRS in New York.
Your documents, especially Forms 5498, can help you calculate your total investments in your Roth IRA over the years. And Form 8606, perhaps from a federal tax return filed in previous years, might include assets added via conversion from a regular IRA.
My wife and I have been making nondeductible contributions to an IRA for many years. How and where should we record this? And how will nondeductible contributions affect our taxes, when we start to make withdrawals from the IRA after we retire?
- J.T., Allentown, Pa.
Many taxpayers have never heard of IRS Form 8606: Nondeductible IRA contributions.
This is a pity. Upon first glance, Form 8606 looks needless, another assurance of full employment for accountants. But if you make nondeductible IRA contributions every year, filling out Form 8606 is a worthwhile exercise.
To see why this might be so, look no further than Lines 1 and 2. Line 1 asks you to "enter your nondeductible contributions to traditional IRAs for 2003, including those made for 2003 from Jan. 1, 2004, through April 15, 2004."
Line 2 asks this: Enter your total basis in traditional IRAs. "Total basis" means all the money you've ever invested in IRAs (cumulative contributions) - and for which you haven't taken a deduction, excluding reinvested interest, dividends and capital gains.
Further down Form 8606, which you may download via the www.irs.gov Web site, you might begin to see how basis might come into play if you withdraw money from an IRA funded with nondeductible contributions.
Let's run through a sample exercise.
We'll assume the IRA was valued at $40,000 as of Dec. 31, 2003. We'll assume you withdrew $5,000 from that IRA in 2003. We'll assume, over the years, you made $10,000 in nondeductible contributions to fund that IRA.
To see which portion of that $5,000 withdrawal would be taxed as regular income, do the following: "Take the nondeductible contribution ($10,000), divide it by the combined value of the withdrawal plus the account's total balance ($40,000 plus $5,000), and that gives you your tax-free percentage," said Paul D. Cioffari, a certified public accountant with Filomeno & Co. PC in West Hartford, Conn.
That's $10,000 divided by $45,000 to come up with 0.2222. That decimal, 0.2222, is the portion that is not taxable. You would therefore multiply $5,000 (the amount you withdrew) by 0.2222 to come up with $1,111; that part of the withdrawal would be free of tax. The rest, $3,889 in this case, would be taxed as regular income, assuming you are 59 1/2 or older, Cioffari said.
Matthew Lubanko is a financial columnist for The Hartford Courant, a Tribune Publishing newspaper. E-mail him at firstname.lastname@example.org.