Non-Deductible IRAs and IRS Form 8606

We recently received a reader question about non-deductible IRA contributions, and it got us thinking. Here’s the question:

“My first question pertains to non-deductible IRAs. I have a rollover IRA from a previous 401K. Due to my income, if I ever decided to make additional contributions to this “traditional” IRA, it would have to be a non-deductible contribution. I think that you’ve mentioned that it may not always make sense to contribute to a non-deductible IRA (in addition to a 401K, profit sharing plan, etc) since the money will be taxed at ordinary income when it comes out in the future. This is opposed to being taxed at capital gains rate if you just put the money in a taxable account instead.

My CPA had mentioned that there is an IRS Form 8606 that you can fill out each year that is specific for non-deductible IRA contributions. You simply enter your yearly contribution, and this modifies your IRA tax basis. In the future, when you are ready to take distributions, only a portion of the traditional IRA (only pre-tax contributions) will be taxable. This basically prevents someone from being taxed twice on the same money, according to the IRS.

I was wondering if you were familiar with this entity? I’m not sure if I’m summarizing or understanding it correctly, but this seems like a good way for younger investors to enjoy long term tax-free growth in addition to their other tax-deferred options.”

Non-Deductible IRA Contributions landscape

This is an excellent question, and yes, we are familiar with the beast! There are times when it makes sense to make a non-deductible contribution to a traditional IRA, and other times when it doesn’t.

So, what happens with non-deductible IRA contributions, and how do you keep records for tax purposes when you make them?  We’ll spend some time discussing the merits of the choices, along with a discussion of the tax treatment of nondeductible IRA contributions, as well as IRS Form 8606.

When Non-Deductible IRA Contributions Become an Issue

When we speak of non-deductible IRA contributions, we’re considering traditional IRAs only. Roth IRA contributions are not tax deductible anyway, so they aren’t part of the discussion.

If you’re not familiar with the intricacies of the tax treatment of traditional IRA contributions, we’ll summarize how they work here. Generally speaking, traditional IRA contributions may not be tax-deductible if either you or your spouse are covered by a retirement plan at work and your income exceeds a certain threshold.

(Note: All income numbers below are based on modified adjusted gross income, or MAGI.)

If neither you nor your spouse are covered by a retirement plan at work, then there is no income limit for making a tax-deductible traditional IRA contribution. But, there are two levels of income limits if either of you has a work-related plan.

If you ARE covered by a retirement plan at work, the income limits for 2015 are:

⦁ Married filing jointly: Up to $98,000 -100%; $98,000 to $118,000 – partial; over $118,000 – zero
⦁ Married filing separately: Up to $10,000 – partial; over $10,000 – zero
⦁ Single or head of household: Up to $61,000 – 100%; $61,000 up to $71,000 – partial; over $71,000 – zero

If you are NOT covered by a retirement plan at work, but your spouse is, the limits for 2015 look like this:

⦁ Married filing jointly: Up to $183,000 – 100%; $183,000 to $193,000 – partial; over $193,000 – zero
⦁ Married filing separately: Up to $10,000 – partial; over $10,000 – zero

Without having any specific information from the reader, we can assume that he exceeds at least one of these income thresholds. Thus, he is facing the prospect of making contributions to a traditional IRA that will not be tax-deductible.

IRS Form 8606 – Non-deductible IRAs

Non Deductible IRA ContributionsOnce again, let’s reemphasize that you can make contributions to a traditional IRA even if your income exceeds the limits above. The contributions just won’t be tax-deductible. We’ll discuss that in more detail below, but for now let’s focus on the tax considerations when doing so.

When you make non-deductible contributions to a traditional IRA, those contributions will not be subject to income tax when the money is withdrawn in retirement. Since you get no tax benefit for making the contributions, there is no tax liability upon withdrawal. (Investment earnings on those contributions however, will be taxable.)

That of course could create an accounting nightmare. After all, if you have made both deductible and non-deductible IRA contributions over the past several decades, how could you possibly know which were non-deductible and -therefore – nontaxable upon withdrawal?

The answer is IRS Form 8606 – Non-deductible IRAs. You can file this form for any tax year in which you make a non-deductible IRA contribution. It’s a two page form, and you can view it here to see what it looks like and how it flows.

This form not only gives the IRS a record of your non-deductible (and therefore non-taxable) contributions, but it also serves as your own record. And, with today’s computerized income tax preparation software packages, non-deductible IRA contributions are accumulated and carried forward automatically.

In typical IRS fashion, the Form 8606 includes a series of steps that add this, subtract that, multiply the result by X, and move the total to Form 1040 Line Zilch. If you’ve ever prepared your own taxes, then you know exactly what I mean. But, in summary, the form reports and records the amount of your non-deductible IRA contributions.

This is even more important if you fall into the income level at which your IRA contributions are only partially deductible. Form 8606 handles the calculation for you, or rather it’s done by your income tax preparation software.

The bottom line is that you will have a permanent record that you made non-deductible contributions that also lists the years you made them.

Benefits Non-deductible IRA Contributions

So far, we’ve been discussing the mechanics of how to handle non-deductible IRA contributions. Now, it’s time to take a look at why you might decide to make them.

There are several reasons, and we’ll summarize them here:

  • A non-deductible IRA contribution is still a retirement contribution that will increase your retirement savings above your employer plan.
  • Investment earnings on the plan are tax-deferred, even if the contributions are not tax-deductible.
  • Since the non-deductible contributions will not be taxable upon withdrawal, it represents something of a tax diversification strategy, in which at least some of your retirement income will come to you without creating a tax liability.

Those are just some of the highlights, and there may be even more reasons why you may wish to make a non-deductible contribution.

Should You Make a Roth IRA Contribution Instead of a Non-deductible One?

If you are in an income range where your IRA contribution will not be deductible, you may still have another option. You might want to make a Roth IRA contribution instead.

No, a Roth IRA contribution will not be any more tax-deductible than a non-deductible traditional IRA contribution, but it does have certain advantages. For starters, distributions taken from a Roth IRA are tax free, as long as you are at least 59 1/2 and have been in the plan for at least five years. Traditional IRAs become taxable when you start making withdrawals. If you can’t make tax-deductible contributions either way, then the tax-free withdrawal feature favors the Roth IRA.

You can make a Roth IRA contribution even if you are covered by employer plan. What’s more, the income limits for a Roth IRA are substantially higher than what they are if you are covered by employer plan.

For 2015 Roth IRA income limits are:

⦁ Married filing jointly: Up to $183,000 – 100%; $183,000 to $193,000 – partial; over $193,000 – zero
⦁ Married filing separately (but lived with your spouse): Up to $10,000 – partial; over $10,000 – zero
⦁ Single, head of household, or married filing separately (but did not live with your spouse during the year): Up to $116,000 – 100%; $116,000 up to $131,000 – partial; over $131,000 – zero

It’s important to realize that once you reach these income limits, you are no longer eligible to make a Roth IRA contribution.

A Roth IRA contribution will make more sense if you expect your income will continue to be high in retirement, putting you in a high tax bracket. The Roth IRA would mean that you would have an income source that is not taxable and will not figure into the “taxability” of your Social Security benefits either.

You might use a traditional IRA with a non-deductible contribution if your income tax bracket is high and you need the tax deduction now. This is even more true if you have good reason to suspect that you will be in a much lower tax bracket once you retire.

So, those are the basics of non-deductible IRAs and how you account for them with IRS Form 8606. When deciding whether to make a non-deductible IRA contribution or to go with the Roth IRA instead, be sure to consider all of the factors we discussed here.

Topics: Retirement Planning

One Response to “Non-Deductible IRAs and IRS Form 8606”

  1. Great article….you covered many of my questions that i’ve been having trouble finding answers. Thanks! My income is over the limit for a deductible IRA so I’ve done backdoor roth conversions for last couple years. In 2016 my income has dropped below the Roth IRA limit. i’m pretty close to the limit and could easily move over $116k. I was going to contribute to the Roth IRA this year (direct) but wouldn’t the safer route be the IRA to ROTH IRA backdoor conversion? I won’t have change anything or get a potential penalty if I go the backdoor route. What’s your thoughts?

    One more question about IRA’s, Does the length of your employment matter for potential tax deduction? What if you are covered by employer’s 401k for one month? Are you still out for getting the IRA tax deduction?

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