Non-deductible traditional IRA

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)

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:
 * Form 8606 Nondeductible IRAs
 * Instructions for Form 8606 Nondeductible IRAs

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:

All the dollar amounts are at the beginning of each year.
 * 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.


 * 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.