Nondeductible Contribution Opportunities for IRAs
By: Duane J. Silbernagel
Now that the standard tax filing deadline has passed, I wanted to write about what appears to be an underutilized option in the retirement saving quiver: making nondeductible contributions to a Traditional IRA.
The contribution limit is identical to those of deductible contributions to Traditional IRAs; the difference is how the withdrawal is taxed when assets are distributed from the account. So, why would anyone make a nondeductible contribution to their IRA? Upon distribution, the cost basis is not taxed. Your cost basis is the total amount of the nondeductible contributions in your traditional IRA(s) and must be carefully tracked over the course of the account(s) life. Any growth is taxed at ordinary income tax rates for the year distributed.
Making a nondeductible contribution to a Traditional IRA may also be the route available to a Roth IRA for those individuals who exceed the IRS adjusted gross income limits to fund a Roth, as Traditional IRA assets can be converted to the Roth IRA.
Example: An individual with eligible earned income deposits $5,500 into their IRA as a nondeductible contribution for the current tax year. The individual then opens a Roth IRA and converts the Traditional IRA assets into the Roth IRA. Since the original cost basis ($5,500 nondeductible contribution) will not be taxed upon a conversion, the tax liability created is limited to any growth on the investments over the time that the Traditional IRA was open.
One important rule that must be considered before preforming such a conversion strategy is how much money the individual has in aggregate in Traditional IRA savings. If an IRA plan holder has deductible and nondeductible contributions in their account and desires to do a partial conversion to a Roth IRA, current regulations require them to convert a pro-rata share of nondeductible contributions, deductible contributions, and any earnings. This rule covers all of the individual’s Traditional IRAs in aggregate.
Here is a sample case study to illustrate this rule: Paul has $94,500 in Traditional IRA savings of deductible contributions and earnings, and deposited an additional $5,500 into the IRA as a nondeductible contribution in February of the current tax year. He is not allowed to convert just the $5,500 Traditional nondeductible IRA balance only. If he wants to do a partial conversion of $5,500 from the IRA to a Roth IRA, the IRS would impose the following formula to determine the taxable and non-taxable portions of the conversion (aggregate balances are based on previous 12/31 year end balances):
A conversion of this type would result in $302.50 being allowed to be converted tax-free. The remaining $5,197.50 would be subject to ordinary income tax for the year of conversion. No early withdrawal penalties apply to conversions.
Another strategy may available if Paul works for a company that provides an employer-sponsored retirement plan which allows rollover of IRA assets into the plan. Paul could potentially be able to move his Traditional IRA assets consisting of deductible contributions and earnings into the employer’s plan before 12/31. This would make his 12/31 IRA account balance $0. Paul could then make a nondeductible contribution into the Traditional IRA the following year and immediately convert the assets to a Roth IRA, making it a non-taxable event if no earnings occur prior to the conversion.
How can these strategies potentially be utilized effectively for saving for retirement?
You should consider funding the retirement savings plan that your company has established, if one is available.
If you’re looking for something more than what you can do through the employer’s plan, then consider funding an IRA.
To create the potential for future tax-free distributions of any growth, consider a full or partial conversion to Roth IRA.
When it comes to implementing strategies like these, caution must be exercised. Having a conversation with a financial advisor and a tax advisor who is familiar with these concepts can be beneficial.
For additional information, refer to IRS Publication 590-A “Contributions to Individual Retirement Arrangements (IRAs)” and IRS Publication 590-B “Distributions from Individual Retirement Arrangements (IRAs)”. Both can be found at www.irs.gov/publications.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Waddell & Reed does not provide legal or tax advice. Please consult with a tax professional regarding your personal situation prior to making any financial related decisions.
Duane Silbernagel is a Financial Advisor in Lincoln City, Oregon offering securities through Waddell & Reed, Inc., Member FINRA and SIPC. He can be reached at (541) 614-1322, via email at DSilbernagel@wradvisors.com.
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