Non-deductible traditional IRA

Last major update: 05/19/08 = 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 to a Roth 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 account. Upon distribution, a non-deductible Traditional IRA converts capital gains, which are taxed favorably, into higher taxed ordinary income.

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 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 makes a number of assumptions, all of which are subject to change.
 * Although placing a tax-efficient stock index fund in a non-deductible IRA is generally not a great idea, you may still consider making non-deductible contributions for holding tax-inefficient investments like REIT and bonds.
 * 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 Roth IRA?
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