For various reasons discussed in my MarketWatch article, The Tax Rules That Limit the Deductibility of Your IRA Contributions, traditional IRA contributions may be nondeductible or partially deductible. To the extent that you make nondeductible IRA contributions, they will require a separate tracking system and will complicate the taxation of your traditional, SEP, and SIMPLE IRA distributions.
Next to Roth 401(k)’s and Roth IRAs, nondeductible IRAs can be a great retirement savings vehicle if funded consistently. Like Roth 401(k)’s and Roth IRAs, 100% of contributions are nontaxable. Unlike Roth accounts, earnings on nondeductible IRAs will eventually be taxed as distributions are taken.
Nondeductible IRA Contributions Must be Tracked
Each year that you make a nondeductible IRA contribution, you’re required to report it on IRS Form 8606 – Nondeductible IRAs as part of your tax filing. A separate form is used for each spouse if married.
Once you make your first nondeductible IRA contribution, although it isn’t required, Form 8606 should be included in your federal income tax return every year thereafter, even in years that you don’t make nondeductible IRA contributions. The reason for doing this is because you need to keep a running total of “basis” in your traditional IRAs.
When you take distributions from your non-Roth IRAs, you’re entitled to apply a portion of your basis against the amount of your distributions to reduce the taxable amount. If you haven’t accounted for your traditional IRA basis on Form 8606 every year since you began making nondeductible IRA contributions, this will be problematic come distribution time.
Basis – The Key to Reducing Taxation of IRA Distributions
What is basis and why do you need to keep a running total? Basis is the cumulative total of nondeductible IRA contributions reduced by the cumulative amount that’s been used to reduce the taxable portion of distributions from traditional, SEP, and SIMPLE (i.e., non-Roth) IRAs.
If you haven’t included Form 8606 as part of your tax returns each year since you began making nondeductible IRA contributions, it will be difficult, if not impossible, for you to reconstruct your traditional IRA basis. You may have made your first nondeductible IRA contribution when you were 25 and are now taking your first distribution from your traditional IRA at age 70-1/2.
Unless you’ve saved all of your income tax returns for the last 45 years or have maintained a traditional IRA basis spreadsheet, you won’t know the amount of your traditional IRA basis. Consequently, 100% of the distributions from your traditional, SEP, and SIMPLE IRAs will be taxable.
Don’t Forget the Total Value of All of Your Non-Roth IRAs When Taking Distributions
In addition to tracking basis, Form 8606 is used to calculate the taxable portion of non-Roth IRA distributions whenever you have made nondeductible IRA contributions in the current year or a previous year.
The total value of all of your traditional, SEP, and SIMPLE IRAs as of December 31 in the year of distribution must be reported on Form 8606 whenever you take a distribution from one of those types of accounts. Inherited and Roth IRAs are excluded. You cannot simply use the value of the account from which you took your distribution assuming you have other non-Roth IRA accounts.
The basis in your traditional IRAs relative to the adjusted value of your non-Roth IRA accounts is used to calculate a percentage that’s used to determine the amount of basis that can be used to reduce otherwise taxable IRA distributions. The higher the percentage, the greater the reduction.
Are Nondeductible IRA Contributions Worth the Effort?
Calculating and keeping track of traditional IRA basis is a lifetime project. It begins the first year that you make a nondeductible IRA contribution and continues until you have no basis remaining in your traditional IRAs. This could be for the rest of your life assuming that you continue to own any traditional, SEP, or SIMPLE IRA accounts.
Given the fact that allowable nondeductible IRA contributions are limited to a maximum of $5,500 or $6,500 a year if 50 or over, are they worth the effort? The answer depends upon the frequency and amount of your nondeductible IRA contributions, other potential sources of retirement income, and level of tax expertise.
If your nondeductible IRA contributions will be hit or miss and/or minimal in amount, e.g., $2,000 or less per year, it probably doesn’t make sense. This is especially true if you have other significant sources of retirement income, such as 401(k) plans, fixed income annuities, pensions, or Social Security.
If, on the other hand, you and/or your spouse are consistently making maximum nondeductible IRA contributions of $5,500 or $6,500 over ten or more years, the required accounting is probably worth the effort. This is especially true if you wouldn’t otherwise set aside the funds in a savings plan dedicated to retirement and/or your other potential sources of retirement income are limited.
Finally, assuming that you decide to make nondeductible IRA contributions, I recommend that you engage the services of an income tax professional to prepare your tax returns if you aren’t doing so already. Given the complexity of calculating the amount of allowable nondeductible contributions, tracking basis, and calculating the taxable portion of distributions, the potential tax savings from doing it correctly can easily justify the fees.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.