Ask the Expert: Avoiding extra IRA taxes

When I retired in 2001, I transferred my 401(k) account into an IRA. Thirty percent of that money was my after-tax 401(k) contributions. But when I began taking required annual IRA distributions in 2004, I paid taxes on my total distributions. In the future, how can I avoid paying taxes on money that's already been taxed?

By filing tax Form 8606 every year. It tells the Internal Revenue Service about your after-tax contributions. You're right that they are tax-free when you withdraw them. You can reclaim the excess taxes you paid in the past by filing amended tax returns for tax years 2007, 2008, and 2009. (You can't go back more than three years.)

But making after-tax contributions to a retirement account is like adding milk to a cup of coffee. When you drink it, there's milk in every sip -- you can't remove the milk separately. Similarly, part of each IRA distribution is tax-free; but you can't take all your after-tax contributions in a single tax-free withdrawal.

Your 2004 required IRA distribution was based on the account's 2003 year-end balance. Let's say you originally transferred $30,000 of after-tax 401(k) contributions into the IRA. To determine the tax-free portion of the 2004 distribution, divide $30,000 by the total IRA balance at the end of 2003, says Ed Slott, a Rockville Centre tax accountant. If the Dec. 31, 2003, IRA balance was $100,000, then 30 percent of your 2004 distribution was tax-free. "Form 8606 is cumulative. Every year, you update the account balance and percentage," says Slott. "If your total after-tax contributions were $30,000 and you never make additional after-tax contributions, you just keep dividing $30,000 by the prior year's account balance to determine the tax-free percentage of your IRA distribution."

The bottom line After-tax retirement account contributions aren't taxable when you withdraw them.

Websites with more information bit.ly/dE0H8h and bit.ly/gmypjW