According to a recent U.S. Tax Court ruling, if the IRA basis cannot be proved or reconstructed then those after-tax IRA funds can be taxed when withdrawn. This can result in double taxation for the person withdrawing those IRA funds. The court held that hardship distributions from a 401(K) and IRA are taxable and also subject to a 10% early distribution penalty. Whenever a person contributes after-tax funds to an IRA that person must report it on IRS Form 8606. The IRS would then know that those reported funds have already been taxed. After-tax funds can be added to an IRA “either via nondeductible IRA contributions or via rollovers of after-tax retirement funds that were held in an employer plan, such as a 401(k).”
See Ed Slott, Sidestep Tax Hit by Reconstructing IRA Basis, Financial Planning, October 1, 2015.
Special thanks to Jim Hillhouse for bringing this article to my attention.
