Good In Theory, Dangerous In Practice






The Internal Revenue Service (IRS) headquarters in Washington, D.C. The IRS allows individuals to contribute after-tax money to traditional IRAs, but for most taxpayers this may be a bad idea. Photographer: Andrew Harrer/Bloomberg

© 2019 Bloomberg Finance LP

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 like this.

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.






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