Non-deductible traditional IRA

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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.

You may contribute up to the limit specified in IRS Publication 590, which is based on coverage by an employer retirement plan or have a Roth IRA.

The amount that can be deducted from your tax return depends on your filing status and coverage by a retirement plan at work. The amount which falls outside the deductible range on your tax return is the non-deductible IRA contribution.

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.

Income limits for IRA deductions[1]
Filing Status Married Filing Jointly Married Filing Jointly Single Single
Deductibility Full Deduction Partial Deduction Full Deduction Partial Deduction
2008 Tax Year Below $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
2010 Tax Year Below $89,000 $89,000-$109,000 Below $56,000 $56,000-$66,000
2011 Tax Year Below $90,000 $90,000-$110,000 Below $56,000 $56,000-$66,000
2012 Tax Year Below $92,000 $92,000-$112,000 Below $58,000 $58,000-$68,000
2013 Tax Year Below $95,000 $95,000-$115,000 Below $59,000 $59,000-$69,000
2014 Tax Year Below $96,000 $96,000-$116,000 Below $60,000 $60,000-$70,000
2015 Tax Year Below $98,000 $98,000-$118,000 Below $61,000 $61,000-$71,000

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.

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 traditional 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 (see figure) 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 favorably, into higher taxed ordinary income. However if dividends are taxed as ordinary income and long-term capital gains are taxed at 20%, 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. See Backdoor Roth IRA for a detailed discussion.

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. The proportionate allocation rule does not apply to rollovers from an IRA to a QRP (Qualified retirement plan) or 403(b) plan. Instead, a distribution that is rolled from and IRA to a QRP or 403(b) plan is deemed to come entirely out of the taxable portion of the IRA. This exception is necessary because the nontaxable portion of an IRA cannot be rolled into a QRP or 403(b) plan. [2]. You might therefore consider the following:

  • Rollover your deductible IRA and taxable portion of your non-deductible IRA back to a 401(k). You may not want to do this if your 401(k) does not have low-cost options.
  • If you qualify as a self-employed business owner who can open a solo 401(k), you might rollover the deductible IRA and the taxable portion of your non-deductible IRA to a solo 401(k). Fidelity, Vanguard, and T. Rowe Price offer solo 401(k) plans.
Example: Mr Gibbs has a non-deductible traditional IRA that has a value of $30,000 and a $12,000 basis of after tax contributions. He also has a traditional IRA valued at $210,000 consisting of a rollover from a QRP plus some deductible IRA contributions. If he withdraws the $30,000 from his non-deductible IRA he must prorate the basis across his aggregate IRA balances. The basis computation: $12,000/$240,000 x $30,000 = $1,500. Thus $28,500 of the withdrawal would be taxable and the basis in the non-deductible IRA would now be $10,500.

Alternately, if Mr. Gibbs participates in a QRP that accepts rollovers, Mr. Gibbs could rollover, from his two IRAs to the QRP, every dollar above his $12,000 basis. He is left with one IRA containing $12,000 of after tax money. He can either withdraw the $12,000 tax free, or convert it to a Roth IRA. [3]

References

  1. Source: COLA Increases for Dollar Limitations on Benefits and Contributions, IRS. Partial deduction ranges are from 26 U.S. Code § 219 - Retirement savings (26 USC 219(g)(2)(A)ii).
  2. Choate, Natalie Life and Death Planning for Retirement Benefit,6th Edition, pp. 115-116. ISBN 0-9649440-7-3
  3. Choate, Natalie Life and Death Planning for Retirement Benefit,6th Edition, pp. 115-116. ISBN 0-9649440-7-3

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