Should You Contribute to a Non-Deductible IRA?

Usually, I don't answer reader questions. First of all, I'm not a qualified financial advisor and many of the questions are complicated and beyond my knowledge. Second, I simply don't have the time to answer them all. Otherwise, that's all I'd do. Third, these people could get the answer themselves if they'd just care enough to do 30 seconds of work -- ever hear of a site called Google? It can help you find the answer to almost anything.

That said, here's a question I recently received from a reader that I felt was worthy of a post (since it impacts me personally and will be of interest to many of you):

I've heard some financial "gurus" say it is not smart to invest in an IRA if you can't deduct it from you taxes. Example, you have no earned income, or you are enrolled in a plan at work.

My question is why not? Even if I can't deduct the contribution, it still grows tax deferred.

First of all, you have to have earned income to contribute to even a non-deductible IRA. Second, I have my own thoughts on the issue (of course), but before I get to those, here are a few from various sources around the web. First, we'll start with Money magazine, who says that a non-deductible IRA is a good option for people who have exhausted all other (preferred) retirement savings options:

If you're right and you can't contribute to a Roth, you and your wife might want to consider investing in a nondeductible IRA. Why? Well, in May Congress passed a law that starting in 2010 eliminates the restriction barring anyone who makes more than $100,000 from converting a traditional IRA to a Roth. The law provides a back-door way to start putting away money today that can eventually go into a Roth. What you and your wife can do is starting this year invest annually in a nondeductible IRA, which anyone with earned income can do. Come 2010, you can then convert whatever money you've accumulated in your nondeductible IRA to a Roth. And you can continue to contribute to a nondeductible IRA and convert it year after year, in effect skirting the income limitations for doing a Roth.

Good thought. Here's another, related thought on the non-deductible IRA:

If you don’t qualify to make a deductible IRA contribution or a Roth contribution, your only other option is to make a non deductible contribution to a Traditional IRA.  The reason this can make sense is that your investment will grow tax deferred which should help you grow your savings.  In addition, funds in an IRA receive some protection from creditors.  The problem with a non deductible IRA contribution is the complexity of tracking the post tax portion of your IRA.  The problem gets more difficult when you withdraw from your IRA and will likely continue until after you die.

When you make a non deductible contribution to a Traditional IRA, you need to keep track of your non deductible contributions year after year so you don’t end up paying taxes again when you withdraw.  When you make a withdrawal from your Traditional IRA, you need to determine the percentage of your IRA that makes up your original, non deducted contributions.  That percentage of your withdrawal is not taxed because you already paid taxes on that money before you made the contribution.  Now you need to reduce your original non deductible contribution by the amount of un-taxed funds you just withdrew.  The total reduced amount of non deducted contributions is used to make the same calculation when you make your next withdrawal in a future year.  The calculation must include Traditional IRA funds from all of your IRA accounts- including 401(k) rollovers.

So it gets a bit complicated, but you can work through that issue if you're prepared for it in advance and you keep good records. Here's a bit more clarity on the non-deductible IRA issue:

If you cannot deduct your contribution yet make one anyway, you must file IRS Form 8606, Nondeductible IRAs (Contributions, Distributions, and Basis), every year you add to or make a withdrawal from an IRA. This form tells the IRS that you already paid taxes on a portion of the money that you had contributed to the IRA.

What happens if you don’t file the form, or if you file but fail to keep a record of it for the rest of your life? There is a $50 penalty for failing to file, and if you don’t keep your records in order, you’ll have to pay taxes when you withdraw the money — even though you already paid taxes when you contributed to the IRA years earlier. Indeed, you’ll pay taxes twice on the same money!

Personally, I contribute the maximum to a non-deductible IRA. I'm looking to get as much income as possible earning as much as possible and out of the tax man's hands -- and it offers this option to me. However, I'm not sure my record keeping is up to snuff. I just emailed my accountant to make sure we're ok -- she'll get it all sorted out for me (just another reason I use a CPA to do my taxes.)

Comments

[Finance Buff]

A trick for keeping track of non-deductible contributions is to file 8606 every year even if you didn't add or withdraw any money. You are not required to file 8606 if you didn't add or withdraw, but if you file it anyway, it will document your basis. You will always know your basis by looking at last year's tax return.

[Bill Thornburg]

I recently went through just this analysis regarding non-deductible IRA's for myself. Besides the recordkeeping necessary that FMF correctly indicates (my accountant has been filing these forms for years -- I never knew what they were for...) you have to decide whether the tax advantages outweigh the, er, tax advantages.

Let me explain:

If you invest in a non-deductible IRA you are putting after tax dollars in an account where earnings are tax deferred. You must still pay taxes on the earnings, but not until you withdraw when you are presumably at a lower tax rate (be careful on this assumption, because the evidence is more and more that you need as much to live on after retirement as while you are still working).

If you instead leave your money in a taxed account, you will pay taxes each year on the earnings, but you won't face any taxes when you withdraw it, excepting any appreciation of the base amount, which, by the way, you must also pay taxes on if the money is in a non-deductible IRA.

So you are trading the tax advantage of tax deferred earnings, versus the tax advantage paying a lower rate on withdrawals. This is a non-brainer if you assume a dramatically lower tax rate in retirement than when you are working -- the advantage is always in favor of the tax-deferred account. But as I looked at my living style and thought hard about how I'd like to live after retirement, I came to the same conclusion FMF comes to -- I will need almost as much anually when in retirement as before retirement, so I assume only a slightly lower tax rate in retirement as when I'm working.

I built a spreadsheet to model this. You have to try various combinations of:
1. The earnings rate on the invested amount (I used the same rate in both approaches, which is reasonable since in most cases you should assume you will earn the same amount on your money whether in a tax deferred or taxable account)
2. The numbers of years the money is in the accounts
3. Your tax rate while you are working and then after you retire
4. The capital gains tax rate when you withdraw (on the assumption that if the money is in a taxable account you will be wise enough to leave it untouched until you can realize the gains as capital gains rather than short term).

What I found is that FOR ME (assuming a 20 year period of the investments) it makes sense to invest in non-deductible IRAs only if I assume earnings on the investments greater than 7%. At 7% it's about breakeven and less than 7% the advantage swings to not investing in the non-deductible IRA. Assuming 7% earnings rate while you are working is maybe reasonable, but seems overly optimistic after retirement (my asumption is that my effective earings rate will go down as I age because I will shift more and more money into lower-yield, lower-risk investments like bonds).

By the way, I did the same analysis for investing in a 401K. My employer doesn't match anything, so again it's not obvious on the surface which approach is better. In this analysis, it is always better to invest in the 401K -- the advantage of putting before tax money in the account outweighs the disadvantage of the higher tax rate on the withdrawals because you have more money compounding in the account over the period.

[Anne Loring]

I began investing in a deductible IRA in 1986 - the laws changed and the IRA was no longer deductible - I continued over the years to make nondeductible contributions. At this point I don't have my investment records going back to 1986 - and I have my tax records going back to 1989 only. How can I prepare now for when the time comes to withdraw funds to avoid paying taxes on the contributions I made with after tax money. I have not been filing the 8606 regularly. Thank you.

If you use something like taxact.com to file your taxes and you answered all the questions, it auto prepared an 8606 for you.

[Jess Vanhooser]

Does early withdrawal penalty apply to a non-deducted IRA? Thanks