User:Fyre4ce/Non-deductible traditional IRA

A non-deductible Traditional IRA results whenever contributions to a Traditional IRA (tIRA) are not deducted on the taxpayer's tax return. It is not a separate type of account; rather, it is a feature of a Traditional IRA that contributions can be deducted from income (subject to income limitations) or not deducted, at the option of the investor. Non-deductible and deductible Traditional IRA contributions, and Roth IRA contributions, share the same annual limit of $6,000 per year, or $7,000 per year for those 50 and over (as of 2020). Due to the availability of the Backdoor Roth IRA, appropriate situations for non-deductible Traditional IRA investments are very limited; see appropriate uses.

Description
A Traditional IRA allows investors to make either deductible (deducted) or non-deductible (not deducted) contributions, at their option. The annual IRA contribution limit of $6,000, or $7,000 for individuals age 50 and over (as of 2020), applies to all deductible and non-deductible Traditional IRA contributions and Roth IRA contributions. When you make non-deductible contributions to a Traditional IRA, those contributions become after-tax basis within the account. Deductible contributions and all growth within the account are pre-tax, and therefore taxable as income when withdrawn. The IRS requires all withdrawals (including for Roth conversions) from a Traditional IRA to be “pro-rata” between the pre-tax and after-tax portions. For example, if you make a $1,000 withdrawal from a Traditional IRA with a balance of $10,000 and a basis of $6,000, the withdrawal will be 60% ($6,000 / $10,000) non-taxable basis and 40% pre-tax. Therefore, the basis would decrease by $600 to $5,400, and $400 of the withdrawal would be considered taxable income. A fully deductible Traditional IRA is a special case of a Traditional IRA with a basis of 0.

Losses from a Traditional IRA – when you make a withdrawal when the balance is less than the basis – are not tax-deductible, unlike with a taxable account.

Income limits
Deduction of contributions to a Traditional IRA is subject to limitations according to one's Modified Adjusted Gross Income (MAGI):

The maximum contribution limit for 2020 is $6,000, or $7,000 for those age 50 or older. You cannot contribute more than your earned income for the year. Non-working married spouses can also contribute to their own IRAs, even if they did not earn any income. The total contribution for both spouses cannot be greater than the total joint earned income.

If you fall inside the phase-out range, the deduction limit is scaled linearly form 100% to 0. For example, a single filer under age 50 with a MAGI of $72,000 would be able deduct up to $1,800 (=$6,000 * ($75,000 - $72,000) / ($75,000 - $65,000) ) of Traditional IRA contributions.

Because the Roth IRA is strictly better than a non-deductible Traditional IRA, and shares the same contribution limit, you should contribute to a Roth IRA before a non-deductible Traditional IRA. Income limits for Roth IRA contributions are as follows:

Contributions limits are similarly reduced linearly within the phase-out range.

Tracking of basis
Financial institutions that hold Traditional IRAs do not track the basis. When making a Traditional IRA contribution, you do not need to tell the financial institution whether the contribution is deductible or non-deductible. In fact, you do not need to decide whether you want contributions to be deductible until you file your taxes for that tax year. The basis of your Traditional IRA is tracked on IRS Form 8606, which you are required to file with your federal income tax every year your basis changes. The basis of a Traditional IRA increases whenever you make non-deductible contributions. The basis decreases whenever you make a Traditional IRA withdrawal, or Roth conversion, when you have a non-zero basis. You are not required to file a Form 8606 for years where your Traditional IRA basis doesn’t change, even if the basis is non-zero.



The "pro-rata" rule
The pro-rata rule has some unexpected details. The rule is applied to the combined balance of ALL Traditional IRAs, SEP-IRAs, and SIMPLE IRAs that an individual owns. For example, if you have a $10,000 Traditional IRA with a $10,000 basis (all non-deductible contributions) and a $90,000 SEP-IRA, a $10,000 withdrawal from the Traditional IRA, only 10% ($10,000 / ($10,000 + $90,000)) will be withdrawal of basis and 90% will be taxable. Even though the Traditional IRA has a balance of $0 and could even be closed, the remaining $9,000 of basis is effectively transferred to the SEP-IRA.

The pro-rata rule is applied based on the combined balance of all Traditional, SIMPLE, and SEP-IRAs as of December 31st of the year in which the withdrawal is made. This gives the taxpayer some flexibility, for example, to roll over a Traditional IRA into a 401k later in the year after making a Backdoor Roth IRA contribution.

A spouse’s IRA balances are not considered in the pro-rata calculation. Neither is an inherited Traditional IRA. If you have an inherited Traditional IRA with a non-zero basis, you will need to file a separate Form 8606 for withdrawals from that IRA. If you are the decedent's spouse, you have the option to combine the Traditional IRA with your own, in which case the basis and pre-tax balance would transfer to you, and you would continue to file a single Form 8606.

Exceptions to the “pro-rata” rule
There are two exceptions when funds withdrawn from a Traditional IRA are not subject to the pro-rata rule:


 * When a Traditional IRA is rolled into a 401(k) or other qualified plan, only the pre-tax portion is rolled over. The non-deductible basis remains within the IRA, which could subsequently be converted to a Roth IRA tax-free.
 * When making Qualified Charitable Distributions (QCDs) from a Traditional IRA, only the pre-tax portion is removed, keeping the basis intact.

Backdoor Roth IRA
The Backdoor Roth IRA is a process used to indirectly contribute to a Roth IRA for taxpayers whose Modified Adjusted Gross Income prevents them from contributing to a Roth IRA directly. There are two steps to a Backdoor Roth IRA:


 * Non-deductible contribution to a Traditional IRA
 * Conversion (usually, shortly thereafter) of the entire Traditional IRA to a Roth IRA

The net result of these two transactions is the same as a direct contribution to a Roth IRA. Neither of these two steps has any income limitations, and so taxpayers of any income can make Backdoor Roth IRA contributions. Aside from the complexity, there is no real disadvantage to using the Backdoor process. If your income will fall close to the limit for direct Roth IRA contributions, it is usually wise to use the Backdoor process just in case. This is especially true if you make your IRA contributions early in the year, but won’t know your exact MAGI until the end of the year or possibly later.

Any gains on investments during the period between contribution and conversion are taxable as income in the year the conversion is made. If the investment loses money during contribution and conversion, these losses are unfortunately not deductible.

Due to the pro-rata rule, if you have any other Traditional IRAs, SEP-IRAs, or SIMPLE IRAs with pre-tax balances, the Backdoor Roth IRA will not work as intended, and will instead be mostly a conversion of pre-tax IRA balance. For those with an income high enough to need the Backdoor Roth IRA, this will result in a significant tax cost. See the main article for a discussion of ways to dispose of a pre-tax IRA that is preventing Backdoor Roth IRA contributions.

Appropriate uses
Non-deductible Traditional IRA contributions are the first step in making Backdoor Roth IRA contributions, and are most commonly used for this strategy.

The availability of the Backdoor Roth IRA makes cases rare where long-term investments in a non-deductible Traditional IRA make sense. This is appropriate only if ALL the following conditions apply:


 * 1) Your income makes you ineligible for deductible Traditional IRA and Roth IRA contributions.
 * 2) You have a Traditional IRA, SEP-IRA, and/or SIMPLE IRA with a large pre-tax balance, which prevents making Backdoor Roth IRA contributions, and that can’t be disposed of:
 * 3) The pre-tax balance is too large to convert to a Roth IRA all at once for a reasonable tax cost
 * 4) You don’t have a 401(k) or other employer retirement account that will accept a rollover from your Traditional IRA (or the fees and investment options from the 401k are too poor for this to be advisable)
 * 5) You are unable or unwilling to start a business and open a Solo 401(k) that can accept the Traditional IRA as a rollover. See this thread in the forum for a discussion of legal requirements for opening a Solo 401(k).
 * 6) You plan on investing in tax in-efficient investments that would favor a non-deductible Traditional IRA over a taxable account; see below
 * 7) You plan on holding the investment for a long enough time (decades) for the difference in performance, compared to a taxable account, to be significant
 * 8) The long-term performance advantage outweighs the superior liquidity of a taxable account
 * 9) You are confident you will spend the money during your lifetime, as opposed to leaving it as part of your estate

Comparisons with other accounts
The following table summarizes the differences between the three types of individual IRA investments and a taxable account:

Roth IRA
A Roth IRA will always be as good or better than a non-deductible Traditional IRA. In both cases contributions are after-tax, but all future growth and withdrawals from a Roth IRA are tax-free, whereas the withdrawal of growth from a Traditional IRA is taxable as income. A Roth IRA and Traditional IRA share the same annual contribution limit. A Roth IRA has an income limit for contribution, whereas a non-deductible Traditional IRA does not. This income limit can be circumvented with the Backdoor Roth IRA.

Deductible Traditional IRA
If you are eligible to deduct contributions to a Traditional IRA (subject to the income limitations above), it is almost always better to do so. Deducting the contributions is effectively an interest-free loan from the government. Only in unusual situations where marginal tax rates are very low today and will be much higher at withdrawal would it make sense to elect not to deduct contributions, but in these situations a Roth IRA should be available and would be a better alternative.

Taxable account
A taxable account has key similarities to a non-deductible Traditional IRA: contributions are made after-tax, and upon withdrawal, growth is taxable, whereas basis is returned tax-free. Any yield (interest, dividends, capital gains distributions) from investments within a taxable account are taxable in the year they are earned, whereas a Traditional IRA is fully tax-deferred. However, a taxable account has several important advantages. Qualified dividends and long-term capital gains are taxed at a reduced rate (as low as 0%) compared to ordinary income. Taxable accounts also have no contribution limits and no withdrawal restrictions; a Traditional IRA is a retirement account with a low annual contribution limit, and withdrawals prior to age 59.5 are assessed a 10% penalty, if certain exceptions don’t apply. The following table summarizes the differences between a non-deductible Traditional IRA and a taxable account.

Performance
Evaluating the performance of a non-deductible Traditional IRA is straightforward; the non-deductible basis stays constant, and the value grows according to the investment's rate of return. Upon withdrawal, the difference between the value and the basis is taxed as ordinary income. Variables are defined as follows:

$$ \begin{align} t & = \text{time} \\ V(t) & = \text{investment value at time t} \\ B & = \text{non-deductible basis} \\ r & = \text{overall rate of return} \\ tr_{w} & = \text{tax rate on withdrawals} \\ \end{align} $$

If the investment compounds continuously, the value of the investment at any future time t can be written as follows. The formula uses exponentials of base e $$\approx$$ 2.71828.

$$ \begin{align} V(t) & = V(0) \cdot e^{(r \cdot t)} \end{align} $$

For periodic (for example, annual) compounding, the investment value is as follows. When analyzing a periodic compounding investment, make sure the period on the rates of growth matches the compounding period. For example, a monthly compounding investment with an annual rate of return of 8% would have a periodic return of ~0.667% (8% / 12). Time should also have the units of number of compounding periods, eg. number of months.

$$ \begin{align} V(t) & = V(0) \cdot (1 + r)^{t} \end{align} $$

Finally, the after-tax value of the account is:

$$ \begin{align} \text{after-tax value} = V(t) - \left ( V(t) - B \right ) \cdot tr_{w} \end{align} $$

Example table
You want to invest $6,000 of pre-tax earnings in a mutual fund and plan to sell it after 30 years. Your federal marginal tax rate is 24% on ordinary income and 15% on qualified dividends and long-term capital gains. The mutual fund has an expected total return of 9%, with capital appreciation of 7% and a dividend yield of 2%, with the latter 100% qualified. The balances and bases (where appropriate) for a deductible Traditional IRA, Roth IRA, non-deductible Traditional IRA, and a taxable account are shown in the table below:

A spreadsheet that can reproduce the table is on the 'Non-ded. IRA' tab of the Case Study Spreadsheet One may enter different assumptions there to see how results change.

Comparison between non-deductible tIRA and taxable accounts
The following analysis looks at four investments over a span of up to 40 years in a non-deductible Traditional IRA (ND tIRA) and a taxable account. The investor is assumed to have a marginal tax rate of 24% for ordinary income and 15% for qualified dividends and long-term capital gains. The investor contributes $6,000 after-tax per year for up to 40 years.



The following conclusions can be reached by analyzing the performance of a taxable account compared to a non-deductible Traditional IRA:


 * Tax efficient investments, such as passive stock funds, perform better in a taxable account
 * Tax inefficient investments, such as corporate bonds and REITs, perform better in a non-deductible Traditional IRA
 * The performance advantage for a non-deductible Traditional IRA is greater over a longer period of time, and when marginal tax rates are higher

Stock fund

 * Total Return: 9%
 * Yield: 2%
 * Qualified Yield: 90%

50/50 stock/bond blend

 * Total Return: 7%
 * Yield: 3%
 * Qualified Yield: 30%

Corporate bond fund

 * Total Return: 4%
 * Yield: 4%
 * Qualified Yield: 0%

REIT

 * Total Return: 6%
 * Yield: 6%
 * Qualified Yield: 0%