NON-DEDUCTIBLE IRAs: GOOD IN THEORY,
DANGEROUS IN PRACTICE
By Raul Elizalde
You know the basics of Traditional IRAs: not only you get a tax deduction
when you make a contribution (subject to limits) but you also get to grow more
of it because you do not pay taxes on gains. This, of course, does not mean that
you avoided taxes – you simply deferred them until you start taking funds out of
your IRA later on. That is why the IRS requires you to start withdrawing as soon
as you turn 70 ½.
The tax advantages of contributing to IRAs are considerable if you can deduct
your contributions during high-tax-rate years, grow them on a tax-deferred basis
and withdraw your funds years later, when your tax rate is likely to be lower.
During your peak-earning years, however, you may not qualify for a deduction
on your IRA contributions if your income is too high.
The IRS still lets you make after-tax contributions to a Traditional IRA. The
benefit of doing this is that you still defer paying taxes on gains just like
for deductible, before-tax contributions. This sounds like a good idea on paper,
but you should be mindful of the risks involved.
First, it is up to you to tell the IRS that you have made a non-deductible
contribution. You do this by filing form 8606, and it is the only way of
informing the IRS that you are putting after-tax money in your IRA. If you don’t
do it, the IRS will charge taxes on the entire distribution later on rather than
just on the before-tax contribution. In other words, you will end up paying
taxes twice. Let a knowledgeable CPA do your taxes and you will avoid mistakes
Second, it may be a good idea to keep contributions in separate IRA accounts
– one for the deductible contributions, and another for non-deductible
contributions. Both will grow tax-deferred, but while the “basis” of the
deductible IRA is zero, you may find it easier to track the “basis” of the
non-deductible IRA if the accounts are separate. While the initial basis is
simply the sum of your after-tax contributions, in later years the basis
calculation is not straightforward.
This is because you cannot choose which account you distribute from, hoping
that you could come with a good withdrawal strategy. Once you have made an
after-tax contribution, you must use form 8606 again every time you make a
distribution from either IRA to establish how each distribution will be taxed.
The IRS treats all your IRAs together and tells you how to break down your
withdrawals into taxable and non-taxable tiers.
This is how: Suppose you have a non-deductible IRA worth $10,000 with a basis
of $5,000, plus a deductible IRA worth $90,000. You divide the basis ($5,000) by
the total value of your IRAs ($100,000) and use that ratio ($5,000/$100,000 =
5%) as the portion that will be considered non-taxable. If you take a $1,000
distribution, for example, $50 will be non-taxable and $950 will be taxable. It
does not matter if you take everything out of the non-deductible IRA first and
its value eventually reaches zero. Your basis will only decrease by that
non-taxable amount next time you take a distribution.
Third, keep in mind that your IRA distributions are taxed at the ordinary
income rate, but many investors pay lower rates on long-term capital gains or
qualified dividends. This means that while the after-tax money you put in a
non-deductible IRA could grow faster than in a regular brokerage account
(because it’s tax-deferred), your withdrawal may be taxed at a higher rate than
a taxable account where you can break down the nature of your gains.
Finally, do not forget that an IRA does not get a step-up in basis to those who will inherit it, but a taxable account does. Therefore, if you think that there will be a sizable amount left in your IRA after you pass away, it may not make sense to pad the IRA even more with after-tax contributions. Non-deductible IRAs sound good in principle, but you may well find that all the extra forms were not worth the trouble, and could even result in higher taxes.