Don’t Pay Taxes Twice: Here’s How to Save Thousands on IRA Distributions

An audit of Susan’s IRA activity revealed that she paid income tax on $50,000 that qualified to be tax-free. Susan mistakenly believed that her IRA custodian would inform her how much of her distribution was nontaxable. She was wrong. As the person responsible for certain administrative functions for her IRA, she is responsible for knowing how much of her distribution is tax-free. The following explains how Susan made the mistake and the corrective steps that were taken.

Why $50,000 Qualified to Be Tax-Free

Susan’s traditional IRA balance in 2024 was $1 million. It consisted of:

• $900,000 in regular traditional IRA contributions for which she claimed tax deductions, pretax amounts rolled over from her 401(k), and earnings accrued in her traditional IRA.
• $40,000 in nondeductible or aftertax traditional IRA contributions.
• $60,000 in rollovers of aftertax amounts from her 401(k).

This breakdown resulted in her IRA balance being 90% pretax and 10% aftertax.

Because the $900,000 is from pretax (not-yet-taxed) amounts, distributions of those amounts would be taxable.

Because the $100,000 is from amounts that have already been taxed, distributions from that $100,000 are tax-free.

Susan withdrew $500,000 from her IRA in 2024.

Tax Insight

Under the pro rata rules for distributions from IRAs, the $500,000 withdrawal included a proportional amount of pretax and aftertax dollars, with $450,000 taxable and $50,000 tax-free. For examples of exceptions to the pro rata rule, see How to Make a Tax-Free Donation From Your IRA and Key Rules for a Backdoor Roth IRA Contribution.

Yet, Susan reported the entire $500,000 on her tax return as taxable.

What Went Wrong

Susan did not file IRS Form 8606.

When Susan sent in checks for her contributions to her IRA custodian, she wrote “nondeductible” in the memo field. When she rolled over the aftertax portion of her 401(k) to her traditional IRA, she sent her custodian a copy of the 401(k) statement showing the breakdown between pretax and aftertax amounts.

Susan mistakenly believed that her IRA custodian would use that information to track her aftertax amounts and show the taxable versus nontaxable amounts on her Form 1099-R, just like her 401(k) administrator had done.

But IRA custodians do not track aftertax amounts and aren’t required to do so. They have no way of knowing how much of an IRA balance is aftertax. That responsibility rests with the IRA owner. Consequently, her IRA custodian reported the entire $500,000 as taxable.

Planning Tip

Your IRA custodian will report regular distributions from your traditional IRA as fully taxable by inputting the amount in Box 1: Gross Distribution and Box 2a: Taxable Amount of your Form 1099-R. However, they must also check Box 2b: Taxable Amount not Determined, leaving room for your tax preparer to override Box 2a if applicable and claim any aftertax amount as nontaxable on your tax return.

As a do-it-yourself investor (and a smart one, just not an IRA expert), Susan treated Box 2a of her 1099-R as accurate and included the full $500,000 as taxable on her tax return. She assumed the entire aftertax amount in her IRA would be claimed as tax-free in the future.

The notes she wrote to the custodian? Not helpful.

What she should have done was file IRS Form 8606, which informs the IRS how much of your IRA balance includes aftertax amounts and should be filed:

• For every year a nondeductible contribution is made.
• For every distribution that includes aftertax amounts.
• For every Roth conversion that includes aftertax amounts.

Failing to file Form 8606 when required can result in overpaying taxes, as it did in Susan’s case.

Fixing the Mistake

Susan had not filed Form 8606 for her nondeductible contributions to her traditional IRA. Fortunately, this was easily fixed. She worked with a CPA to:

• File Form 8606 retroactively for each year she made nondeductible contributions.
• File Form 8606 for 2024 to report the proper breakdown of her $500,000 distribution.
• Amend her 2024 tax return, which resulted in the $50,000 accurately treated as nontaxable.

Filing Tip

Always use the version of Form 8606 that applies to the year the activity occurred. For example, Susan made a $5,000 nondeductible IRA contribution for 2020. Therefore, her CPA filed Form 8606 for 2020, reporting the $5,000 as a nondeductible IRA contribution, even though the form was filed in 2025.

IRA Lessons From Susan’s Case

Use the following tips to help protect your IRA from such mistakes.

Document and Track Contributions

When you contribute to your traditional IRA, it may be deductible or nondeductible.

Your tax preparer can use the IRA Deduction Worksheet in the Form 1040 instructions to determine the deductible amount.

Deductible contributions are reported on Line 20 of your tax return.

If you do not claim a deduction, either by choice or because you’re ineligible to do so, your contribution is nondeductible, and Form 8606 must be filed to report the nondeductible treatment.

Understand IRA Distributions

Distributions from your traditional IRA are taxed as ordinary income. But if part of your IRA includes aftertax amounts, distributions of those amounts are not taxable.

You can’t withdraw only the aftertax amount. Instead, distributions are prorated between pretax and aftertax amounts across all your traditional IRAs, SEP IRAs, and Simple IRAs.

Note: Roth conversions count as distributions for this purpose.

If you have aftertax amounts in your IRA and you convert to a Roth, filing Form 8606 is required.

Keep Detailed Records

Failing to track your basis can lead to paying income tax on amounts that should be tax-free.

To prevent that, keep detailed records of:

• All IRA contributions.
• Rollovers from employer plans, particularly aftertax amounts.
• Form 5498, which shows contributions made to your IRA.
• Form 1099-R, showing all distributions from your traditional IRAs.
• Your tax returns.

If you’re unsure whether you have aftertax amounts in your IRA, ask your CPA to audit your IRA history. They’ll need access to the above documents to help you identify any missed opportunities or tax reporting errors.

Going Forward for Susan

If Susan finds that any future traditional IRA contribution is nondeductible, she should consider making that contribution to a Roth IRA instead, if eligible. If she is not eligible to make a regular contribution to a Roth IRA, she should consult with her tax advisor about using the backdoor Roth IRA contribution strategy to shift aftertax amounts to a Roth IRA.