Non-deductible Traditional IRA
From Bogleheads
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The rules about a non-deductible Traditional IRA are complicated and often misunderstood. Also, the utility of a non-deductible IRA is somewhat limited. This page is intended to address frequently asked questions about a non-deductible Traditional IRA.
What is a non-deductible Traditional IRA?
A non-deductible Traditional IRA is a Traditional IRA that consists of non-deductible contributions. If you are covered by a retirement plan at work, and your Modified Adjusted Gross Income exceeds the income limit in the table below, you cannot deduct contributions to a Traditional IRA.
IRS Publication 590 Individual Retirement Arrangements (IRAs)
| Filing Status | Married Filing Jointly | Married Filing Jointly | Single | Single |
| Deductibility | Full Deduction | Partial Deduction | Full Deduction | Partial Deduction |
| 2008 Tax Year | Under $85,000 | $85,000–$105,000 | Below $53,000 | $53,000–$63,000 |
| 2009 Tax Year | Below $89,000 | $89,000-$109,000 | Below $55,000 | $55,000-$65,000 |
Additional information regarding partial deductibility limits can be found at Who can contribute
If you contribute to a non-deductible IRA you are required to file and retain a copy of IRS Form 8606. In addition to satisfying the IRS, it is essential to permanently retain copies of the 8606 since the form provides a record of your tax basis in the IRA. This is required information for determining the proper tax imposed on IRA withdrawals.
Links:
What is a difference between a Roth IRA and a non-deductible Traditional IRA?
In both Roth IRA and non-deductible Traditional IRA, contributions are non-deductible, meaning that you fund them with after-tax money. The major difference comes from the way earnings are taxed. Earnings are taxed as ordinary income if you withdraw them from a non-deductible Traditional IRA. In contrast, earnings are tax free if you withdraw them from a Roth IRA.
Is a non-deductible Traditional IRA right for me?
First, see if you are eligible for a Roth IRA. If you are, a Roth IRA is strictly better than a non-deductible Roth IRA because earnings are tax free in a Roth IRA.
If you are not eligible for a Roth IRA, then the answer is somewhat complicated. See other questions on this page for details.
How do I make non-deductible contributions to a Traditional IRA?
You make non-deductible contributions to a Traditional IRA by sending money to an IRA custodian of your choice. You do not need to notify the IRA custodian that you are making non-deductible contributions. However, you do need to notify IRS that you have made non-deductible contributions to a Traditional IRA with Form 8606 Nondeductible IRAs when you file your tax return. It is your responsibility to keep track of the basis (the amount of non-deductible contributions) in your Traditional IRA.
What kind of investments are well suited to a non-deductible Traditional IRA?
Tax inefficient investments such as REIT and bond funds are well suited to a non-deductible Traditional IRA.
Whether a tax efficient fund comes out ahead in a non-deductible IRA or in a taxable account depends on (1) your assumptions on tax rates; (2) your investment time horizon; and (3) whether you are planning to convert your non-deductible Traditional IRA to a Roth IRA in 2010 and/or thereafter. Upon distribution, a non-deductible Traditional IRA converts capital gains, which are taxed favourably, into higher taxed ordinary income. However if dividends are taxed as ordinary income and long-term capital gains are taxed at 20% starting in 2011, the tax deferral inside a non-deductible IRA and a long investment holding period can overcome the tax rate difference.
Below is a table showing the growth of a $10,000 investment in a tax-efficient stock index fund held in various accounts. Assumptions are:
- 28% federal income tax bracket (before and after retirement in 2038)
- 15% federal income tax for qualified dividends and long-term capital gains
- 0% state income tax
- 2% dividends paid at year's end, with the entire amount being qualified dividends
- 6% capital appreciation per year
- The entire investments are cashed at the beginning of 2038 at the above tax rate
- Tax Loss Harvesting is not performed in a taxable account.
All the dollar amounts are at the beginning of each year.
| Year | Taxable (cost basis) | Roth IRA | Deductible Traditional IRA | Non-deductible Traditional IRA |
|---|---|---|---|---|
| 2008 | $7,200.00 ($7,200.00) | $7,200.00 | $10,000.00 | $7,200.00 |
| 2009 | $7,754.40 ($7,322.40) | $7,776.00 | $10,800.00 | $7,776.00 |
| 2010 | $8,351.49 ($7,454.22) | $8,398.08 | $11,664.00 | $8,398.08 |
| 2011 | $8,994.55 ($7,596.20) | $9,069.93 | $12,597.12 | $9,069.93 |
| 2012 | $9,687.13 ($7,749.11) | $9,795.52 | $13,604.89 | $9,795.52 |
| 2013 | $10,433.04 ($7,913.79) | $10,579.16 | $14,693.28 | $10,579.16 |
| 2014 | $11,236.39 ($8,091.15) | $11,425.50 | $15,868.74 | $11,425.50 |
| 2015 | $12,101.59 ($8,282.17) | $12,339.53 | $17,138.24 | $12,339.53 |
| 2016 | $13,033.41 ($8,487.90) | $13,326.70 | $18,509.30 | $13,326.70 |
| 2017 | $14,036.98 ($8,709.46) | $14,392.83 | $19,990.05 | $14,392.83 |
| 2018 | $15,117.83 ($8,948.09) | $15,544.26 | $21,589.25 | $15,544.26 |
| 2019 | $16,281.91 ($9,205.10) | $16,787.80 | $23,316.39 | $16,787.80 |
| 2020 | $17,535.61 ($9,481.89) | $18,130.82 | $25,181.70 | $18,130.82 |
| 2021 | $18,885.85 ($9,779.99) | $19,581.29 | $27,196.24 | $19,581.29 |
| 2022 | $20,340.07 ($10,101.05) | $21,147.79 | $29,371.94 | $21,147.79 |
| 2023 | $21,906.25 ($10,446.83) | $22,839.62 | $31,721.69 | $22,839.62 |
| 2024 | $23,593.03 ($10,819.24) | $24,666.79 | $34,259.43 | $24,666.79 |
| 2025 | $25,409.70 ($11,220.32) | $26,640.13 | $37,000.18 | $26,640.13 |
| 2026 | $27,366.24 ($11,652.29) | $28,771.34 | $39,960.19 | $28,771.34 |
| 2027 | $29,473.44 ($12,117.51) | $31,073.05 | $43,157.01 | $31,073.05 |
| 2028 | $31,742.90 ($12,618.56) | $33,558.89 | $46,609.57 | $33,558.89 |
| 2029 | $34,187.10 ($13,158.19) | $36,243.60 | $50,338.34 | $36,243.60 |
| 2030 | $36,819.51 ($13,739.37) | $39,143.09 | $54,365.40 | $39,143.09 |
| 2031 | $39,654.61 ($14,365.30) | $42,274.54 | $58,714.64 | $42,274.54 |
| 2032 | $42,708.01 ($15,039.43) | $45,656.50 | $63,411.81 | $45,656.50 |
| 2033 | $45,996.53 ($15,765.47) | $49,309.02 | $68,484.75 | $49,309.02 |
| 2034 | $49,538.26 ($16,547.41) | $53,253.74 | $73,963.53 | $53,253.74 |
| 2035 | $53,352.71 ($17,389.56) | $57,514.04 | $79,880.61 | $57,514.04 |
| 2036 | $57,460.87 ($18,296.56) | $62,115.17 | $86,271.06 | $62,115.17 |
| 2037 | $61,885.36 ($19,273.39) | $67,084.38 | $93,172.75 | $67,084.38 |
| 2038 | $66,650.53 ($20,325.44) | $72,451.13 | $100,626.57 | $72,451.13 |
| After-tax | $59,701.77 | $72,451.13 | $72,451.13 | $54,180.81 |
- Notice that the after-tax value of the investment in a non-deductible Traditional IRA is 9% less than that of the investment in a taxable account.
- If you perform Tax Loss Harvesting, the difference may be larger.
- Note that the above table makes a number of assumptions, all of which are subject to change. If dividends are taxed as ordinary income and capital gains are taxed at 20%, the picture changes. The after-tax value of the investment in a non-deductible Traditional IRA becomes 2% more than that of the investment in a taxable account.
- Although placing a tax-efficient stock index fund in a non-deductible IRA may or may not be a great idea, you may still consider making non-deductible contributions for holding tax-inefficient investments like REIT and taxable bonds. Also, if you think you will later need more tax-advantaged space to hold tax more inefficient assets, such as REITs, taxable bonds, and commodities, you may still want to put a tax-efficient fund in a non-deductible IRA as a "placeholder" because you cannot retroactively contribute to an IRA.
- You will most likely be investing every year. If you are investing in a taxable account you can choose to sell the least appreciated shares with Specific Identification of Shares right after you retire, which may put you in a very low tax bracket because return of capital is tax free.
How do I convert a non-deductible Traditional IRA to a Roth IRA?
You can convert a non-deductible Traditional IRA to a Roth IRA if:
- your modified AGI for Roth IRA purposes is not more than $100,000, and
- you are not a married individual filing a separate return.
See IRS Publication 590 Individual Retirement Arrangements (IRAs) for details.
If your Modified Adjusted Gross Income exceeds the limit, you cannot convert a non-deductible Traditional IRA to a Roth IRA until 2010 under the current law.
If you are investing with Vanguard, you can find Roth conversion paperwork at IRA and retirement investing.
I have a large Traditional IRA with deductible contributions and/or rollover contributions from an old 401(k). Should I make non-deductible contributions to a Traditional IRA?
Maybe. Maybe not.
If you are planning to convert a non-deductible Traditional IRA to a Roth IRA, which you should strongly consider in 2010, your large deductible Traditional IRA causes one major stumbling block. The IRS treats all of your (but not your spouse's) non-Roth IRAs as one giant IRA. When you make non-deductible contributions to a Traditional IRA, you'll have the basis, the amount of non-deductible contributions, reported on Form 8606. When you convert a part or all of your Traditional IRA to a Roth IRA, the conversion amount must contain the non-deductible portion proportionally. For example, if 5% of your non-Roth IRA are non-deductible contributions, then 5% of the conversion amount must be non-deductible contributions, and the rest must come from the deductible contributions, including earnings and rollover contributions. Notice that you cannot just convert the non-deductible part to a Roth IRA.
There are a couple of ways to work around this problem.
- Rollover your Rollover IRA back to a 401(k). You may not want to do this if your 401(k) does not have low-cost options.
- Rollover your Rollover IRA to a solo 401(k) administered at brokerages like Fidelity. (Vanguard does not offer a solo 401(k) as of this writing.)
If you do either one of these, the balance in your non-Roth IRA significantly drops. In turn, the amount of non-deductible contributions as a percentage of your non-Roth IRA goes up, possibly quite steeply. Since you do not have to pay tax on the non-deductible portion when you do a Roth conversion, the conversion becomes very easy from a tax standpoint. Specifically, the conversion amount consists mostly of non-deductible contributions, so you do not have to pay a lot of tax.
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