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.

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 non-deductible 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 limits), 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.

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 usually makes long-term investments in a non-deductible Traditional IRA inappropriate. They are appropriate only if ALL the following conditions apply:


 * 1) Your income and participation in a retirement plan at work makes you ineligible for deductible Traditional IRA and Roth IRA contributions.
 * 2) You have Traditional IRAs, SEP-IRAs, and/or SIMPLE IRAs with a large total pre-tax balance that can’t be disposed of:
 * 3) 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)
 * 4) 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). A large pre-tax balance may cause more tax than desirable when using the Backdoor Roth process due to the pro-rata rule.
 * 5) You plan on investing in tax in-efficient investments that would favor a non-deductible Traditional IRA over a taxable account; see below
 * 6) 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
 * 7) The long-term performance advantage outweighs the superior liquidity of a taxable account
 * 8) You are confident you will spend the money during your lifetime, as opposed to leaving it as part of your estate

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:

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

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:

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

If the cost basis has not been documented using Form 8606, the IRS may claim tax is due on the entire withdrawal.

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%

Cost basis
Any non-deductible contribution to your traditional IRA creates a cost basis.

Your cost basis is the sum of the nondeductible contributions to your IRA minus any withdrawals or distributions of nondeductible contributions.

To designate contributions as nondeductible, you must file IRS Form 8606 to document the cost basis that should not be taxed at withdrawal. You must file Form 8606 to report nondeductible contributions even if you don’t have to file a tax return for the year.

Failure to report nondeductible contributions. If you don’t report nondeductible contributions, all of the contributions to your traditional IRA will be treated like deductible contributions when withdrawn. All distributions from your IRA will be taxed unless you can show, with satisfactory evidence, that nondeductible contributions were made.

Penalty for overstatement. If you overstate the amount of nondeductible contributions on your Form 8606 for any tax year, you must pay a penalty of $100 for each overstatement, unless it was due to reasonable cause.

Penalty for failure to file Form 8606. Although IRS forms and publications say "you will have to pay a $50 penalty if you don’t file a required Form 8606, unless you can prove that the failure was due to reasonable cause," experience has shown that penalty is (almost?) never assessed if you simply send the IRS any such forms you neglected to file. Send them to the same address you would use for paper-filing form 1040. If the unfiled 8606s do not change the tax owed or refund (e.g., if they merely document a non-deductible contribution), there is no need to file an amended return for those years.

Tax on earnings on nondeductible contributions. As long as contributions are within the contribution limits, none of the earnings or gains on contributions (deductible or nondeductible) will be taxed until they are distributed.