Chapter 2: Income Tax Issues
103
Step 1: How much basis does the participant have?
To determine the participant’s basis
in a QRP, see
¶ 2.2.03 .To determine the participant’s basis in his traditional IRAs, see
¶ 2.2.06 .To determine a beneficiary’s basis in inherited IRAs, see
¶ 2.2.07 .Step 2: How much of a particular distribution is basis?
See
¶ 2.2.04to determine how
much of any particular distribution from a QRP is deemed to be after-tax money. See
¶ 2.2.08to
determine what portion of any particular distribution from a traditional IRA is deemed to be after-
tax money.
Step 3: How much of a partial rollover or Roth conversion is after-tax money?
If a
particular distribution is only partly rolled over, or only partly converted to a Roth IRA, how is
after-tax money allocated between the rolled and nonrolled (or converted and nonconverted)
portions? If a distribution is rolled over to multiple plans or IRAs, how is the after-tax money
allocated among the various “destination” plans? See
¶ 2.2.05to answer these questions with
respect to QRP distributions,
¶ 2.2.08 – ¶ 2.2.10for traditional IRA distributions.
2.2.02
General rule: The “cream-in-the-coffee rule” of § 72
Any distribution from a traditional retirement plan (or IRA) is deemed to carry out
proportionate amounts of the pre- and after-tax money in all of the participant’s account(s) in that
plan (or all of the participant’s traditional IRAs), unless an exception applies.
Here is how we arrive at that general rule:
§ 402(a)provides that QRP distributions are
taxable under the rules provided in
§ 72 . § 408(d)(1)provides similarly for distributions from
IRAs, as
§ 403(b)(1)does for 403(b) plans.
§ 72provides that any distribution from a retirement plan is deemed to carry out
proportionate amounts of the pre- and after-tax money in the plan. See
§ 72(e)(8)(A) , (B) , (5)(D) .Ed Slott, CPA, one of America’s leading IRA experts, the author of several books on retirement
distribution planning and publisher of
Ed Slott’s IRA Advisor
newsletter (se
e Appendix C ), call
s § 72the “
cream-in-the-coffee rule
.” Once after-tax money (cream) has been combined with the
pretax money (coffee) in your retirement plan, every “sip” (distribution) taken from the plan will
contain some cream and some coffee.
Of course, like everything else, the cream-in-the-coffee rule applies differently to IRAs and
nonIRA plans, and has several exceptions (different exceptions for IRAs and nonIRA plans). So,
the task of figuring how much of a particular distribution or rollover contribution consists of after-
tax money will always start with the general “cream” rule, but then follow different tracks for IRAs
and nonIRA plans. And remember, a totally different track applies for Roth IRAs—see
¶ 5.2.06 .Because
§ 72was originally written to deal with distributions from annuity contracts, it
often refers to the “contract,” which can be confusing when dealing with a retirement plan.
2.2.03
Participant’s basis in a QRP or 403(b) plan
This
¶ 2.2.03explains how a participant can get “basis” in his QRP, and how to determine
what the participant’s basis is with respect to such a plan. Once you have determined what the
participant’s basis is,
¶ 2.2.04explains how to tell how much of that basis is included in any
particular distribution.