Tax Reform Complicates IRA Record-Keeping

QUESTION: I am still debating whether to make my usual $2,000 contribution to the IRA I have had for five years now, and I have two questions I hope you can answer. I know that the deadline is April 15 for people who still qualify for a tax deduction for their IRA contribution. But can you tell me whether those of us whose IRA contributions are no longer tax-deductible also have until April 15? Also, if I do add non-deductible contributions to my deductible ones, how on earth will I know, when it comes time to start my withdrawals, which money has already been taxed and which hasn’t?--T. J.

ANSWER: Your first question is easy. The deadline for all 1987 IRA contributions, deductible or non-deductible, is April 15.

Personal finance advisers often advise their clients to make their IRA contributions well before that deadline. The earlier the contribution, they argue, the sooner the interest starts accumulating.

But with tax reform, many tax advisers now say this post-year-end deadline is a blessing for hundreds of thousands of taxpayers who can’t make a decision about IRA contributions until they get their W-2 forms from their employers and compare their actual taxable income for 1987 to the new income limits for IRA contribution purposes.

Under the new law, taxpayers covered by a pension plan at work can no longer get a tax deduction for contributing up to $2,000 per year to an IRA--unless adjusted gross income is $25,000 or less for single taxpayers or $40,000 or less for couples filing jointly.

Partial deductions are still allowed for single taxpayers whose adjusted gross income is more than $25,000 but less than $35,000 and for married taxpayers whose adjusted gross income is more than $40,000 but less than $50,000. No deduction is allowed for single taxpayers whose adjusted gross income is $35,000 or more. For married taxpayers, the limit is $50,000.

Your second point is one that is sure to give taxpayers, financial advisers and IRS agents headaches for years to come.

Before tax reform--whose original purpose was to simplify the nation’s complex tax code--the record-keeping on IRAs was simple. Anyone who made a contribution got an immediate tax deduction and was taxed when he or she began withdrawing the funds. Taxpayers who withdrew money prematurely got slapped with a 10% tax penalty.

Now, deductible contributions will continue to be taxed upon withdrawal. But non-deductible contributions may be withdrawn tax-free because they already have been taxed.

Even if you could keep track of which contributions were taxed and which weren’t, you don’t have the right to designate which type of funds you are withdrawing. Rather, when it comes time to withdraw money, you must determine what percentage of the total funds already has been taxed and then prorate your withdrawals accordingly.

Suppose you have $22,000 in your IRA account when it comes time to start withdrawing money for retirement. Let’s also say that $2,000 of that total was added after tax reform and isn’t tax deductible--meaning you paid taxes on it the year you earned the money, so it won’t be taxed again when you withdraw it from your IRA.

Now let’s suppose you withdraw $2,000 of your $22,000. You cannot avoid paying taxes on the withdrawal by arguing to the IRS that this was the $2,000 you paid tax on long before. Rather, you must calculate the ratio of deductible to non-deductible funds--which in this case is 91%--and apply that ratio to your withdrawal. In other words, your $2,000 withdrawal would be 91% taxable.

So if you are in the 28% income tax bracket the year you withdraw the money, you would be required to pay a $510 tax on the $2,000 withdrawal from your IRA.

If you decide to make a non-deductible contribution, you must file an extra form with the IRS at filing time. It is Form 8606.

Q: I am thinking about turning someone in to the IRS for not paying his taxes. But I know this guy could make my life miserable. Can you tell me how much I can expect to be paid if I snitch?--C. U.

A: The most you would ever receive is $100,000, and few tipsters have ever received that much.

To get any money at all from the IRS in exchange for information, you must provide “specific and responsible information� that triggers an investigation and results in recovery of unpaid taxes. If the IRS can show that it would have been able to collect the taxes without your help, you don’t get any reward whatever.

If your information does qualify for a reward, your payment is based on how much in unpaid taxes the IRS recovers and on how specific your information was.

Specific information is rewarded with 10% of the first $75,000 recovered, 5% of the next $25,000 and 1% of amounts above that--up to $100,000.

If your tip gives the IRS a lead but isn’t specific about the amount of taxes unpaid, you are entitled to receive--depending on the nature of your information and the amount of taxes that the IRS recovers--between 0.5% and 5%, up to a maximum of $100,000.