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November 07, 2006


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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.

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.

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 to file your taxes and you answered all the questions, it auto prepared an 8606 for you.

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

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