Does it make sense to fund a non-deductible individual retirement account (IRA)? Many people who are not eligible to fully fund a deductible IRA and/or Roth IRA often overlook this easy opportunity to sock away additional dollars for retirement. And unlike a 401(k) or other salary deferral plan, you can make contributions up through the April 15 tax filing deadline.
Unlike a traditional IRA, which is tax deductible, non-deductible IRA contributions are made with after tax dollars and provide no immediate tax benefit. In a given tax year, as long as you or your spouse have enough earned or self-employment income, you can each contribute to an IRA. In 2018 the limit is $5,500 with an additional "catch up" contribution of $1,000 if you are age 50 or over. You can continue making contributions until the year in which your reach age 70½, when required distributions must begin. (For more, see: IRA Contribution Limits in 2018.)
Contributions can be allocated across different kinds of IRAs. For example, you could make additions to a tax deductible, non-deductible and/or Roth IRA in a given tax year, as long the combined contributions do not exceed the limit. And, unlike a Roth IRA, deductible and non-deductible IRA contributions can be commingled in the same account.
Unfortunately, eligibility to fund different kinds of IRAs is subject to restrictions based on your income, tax filing status and eligibility to participate in an employer-sponsored retirement plan, even if no contributions have been made to the plan in a given tax year. If you and your spouse do not participate in an employer plan there are no restrictions on fully funding a deductible IRA. However, if either you or your spouse is eligible to participate in an employer-sponsored plan then the following limits apply in 2018:
For a deductible IRA filing as single or head of household eligibility phases out between $63,000-$73,000 of modified adjusted gross income (MAGI) for 2018. For married filing jointly the phase out is between $101,000-$121,000 of MAGI and for married filing single the phase out is $10,000 of MAGI.
For a Roth IRA filing as single or head of household eligibility phases out between $120,000-$135,000 of MAGI. For married filing jointly the phase out is between $189,000-$199,000 of MAGI and for married filing single the phase out is $10,000 of MAGI.
For any year in which you do make a contribution to a non-deductible IRA, you need to include IRS Form 8606 in your federal tax return. This form documents your after tax contribution which is important once you begin taking distributions.
Between ages 59½ and 70½ you are free to take any amount out of your IRA without a penalty. Once you reach age 70½ the IRS requires you to aggregate the value of all your deductible and non-deductible IRAs and begin taking distributions from your traditional (but not Roth) IRAs. If you made non-deductible contributions then any distribution contains both a taxable and a non-taxable portion. The taxable portion is based on the growth of your contributions and the non-taxable portion on your cumulative after tax contributions.
For example, over the years you contributed $50,000 to a non-deductible IRA and by age 70½ the account grew to $75,000. Roughly 33% ($25,000) of the account value would be appreciation and taxable. According to the IRS tables, at age 70½ your required distribution would be 3.65% of the account value or $2,738 and thus about $904 would be taxable. (For more, see: An Overview of Retirement Plan RMDs.)
If you have an IRA that includes both deductible and non-deductible contributions, which could include a rollover from a qualified plan, you would use the same process. For instance, assume instead the $75,000 IRA had $25,000 of non-deductible contributions and the other $25,000 were deductible contributions. Using the same calculation, only about 33% of each distribution would be a tax free return of your contribution.
The computation to determine the taxable and non-taxable ratio needs to be recalculated every year and is based on the December 31 value of all your IRA accounts. The annual distribution is based on tables published by the IRS. For investors who have more than one IRA account the distribution can be drawn from each account or just one.
One downside to non-deductible IRAs is the recordkeeping. It is your responsibility to keep track of and claim any non-deductible contributions. The IRS recommends keeping your 1040 and 8606 forms as well as the Form 5498 that you receive each year from the IRA custodian to document your contributions and distributions. This is important, as upon the death of the IRA owner the cost basis is not lost and does transfer to the spouse or beneficiary.
Annual contributions to a non-deductible IRA are limited, but over time they can really add up. For instance, if you contributed $6,500 a year for 10 years beginning at age 50 and then retired at age 60, assuming a 6% rate of return, your contributions could grow to more than $150,000 by age 70. And once you start taking distributions about 44% would be a tax-free return of your contribution. (For more, see: 11 Things You May Not Know About Your IRA.)