Non-deductible traditional IRA

= Introduction =

The rules about a non-deductible Traditional IRA are complicated and 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 tax 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.

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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.

Unless you are planning to convert your non-deductible Traditional IRA in 2010, you may not want to place a tax-efficient stock index fund in a non-deductible Traditional IRA because the after-tax return of such a fund may be worse in a non-deductible Traditional IRA than in a taxable taxable account. The reason is that a non-deductible Traditional IRA converts capital gains, which is taxed favorably, to ordinary income.

A tax-efficient stock index fund placed in a fully deductible Traditional IRA is perfectly OK even though capital gains are converted to ordinary income. This is because the tax that you do not have to pay tax on deductible contributions, so the tax that you would pay in the non-deductible Traditional IRA case actually produce earnings and compounding in a fully deductible Traditional IRA.

Below is a table of how pre-tax $10,000 grows a tax-efficient stock index fund 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 with the entire amount being qualified dividends are paid at the end of each year
 * 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 slightly 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 assumes a number of things, all of which are subject to change.
 * Although placing a tax-efficient stock index fund is generally not a great idea, you may still consider making non-deductible contributions if you think you need the tax-advantaged space for holding tax-inefficient investments like REIT and bonds in fairly soon.
 * You will most likely 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 Roth IRA?
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