The Best Laid Plans: The Headaches of Accounting for Non-deductible IRA ContributionsSubmitted by Financial Planning Hawaii on October 29th, 2014
NOTE: This article was originally published on NerdWallet here.
Question: What do people dislike more than paying taxes?
Answer: Paying taxes twice on the same income!
For Americans who are ineligible to make tax deductible contributions to a traditional IRA or a Roth IRA, the idea of making a non-deductible (i.e., after-tax) contribution to a traditional IRA may seem like a fiscally responsible decision. Why not take advantage of the government’s offer to allow your contributions to grow tax deferred until withdrawal many years in the future? After all, there are scores of neat tables and graphs produced by myriad financial institutions illustrating the value of tax-deferred compounding , especially over long periods of time.
As with all traditional IRAs, withdrawals from non-deductible IRAs may be made penalty free after the account holder attains age 59 ½ and are required to begin after the account holder reaches age 70 ½ (see IRS Publication 590). The full amount of such distributions is reported to the IRS by the custodial institution on Form 1099-R. In theory, the taxpayer must only pay federal income tax on the portion of the distribution that is attributable to the tax-deferred growth, while the portion attributable to after-tax contributions would not be taxed.
In practice, for many non-deductible IRA holders, the reward for their youthful parsimony is a tax-reporting nightmare when distributions begin. One common unpleasant surprise that befalls some non-deductible IRA owners is that IRA custodians do not automatically keep track of your after-tax contributions. Reporting to the IRS of annual after-tax contributions is supposed to be done on Form 8606 and should accompany the filer’s tax return in the year in which such contributions are made. The trouble is that many tax payers (particularly those who prepare their own returns) are unaware of this form. Absent this form, the IRS has no record of how much after-tax contributions you have made and the burden is on you to prove that you made them. While it is possible to obtain transcripts of prior year tax returns and to file Form 8606 for the appropriate years, given that non-deductible IRA contributions have been permitted since 1987, the prospect of obtaining and sorting through a quarter century of tax returns may present an insurmountable obstacle to avoiding double taxation.
Even for those who were savvy enough to file Form 8606 and who have maintained meticulous records of after-tax contributions, teasing out the after-tax contributions is still not as simple as one would think. Many investors mistakenly believe that, as long as they have maintained their non-deductible IRAs separate from their pre-tax funded traditional and rollover IRAs, the money they withdraw from their non-deductible IRAs will be taxed according to the ratio of contributions to the value of the account. In reality, however, the IRS requires the taxpayer to consider the after-tax contributions in relation to the total value of ALL IRAs. For investors with considerable IRA holdings, this often means that only a very small percentage of their non-deductible IRA distributions may be considered exempt from taxation.
As this point, some astute investors may say, “Aha! I have a solution – why not convert the entire value of the non-deductible contributions to a Roth IRA.” Bad news, mes amis - Uncle Sam is one step-ahead. While it is certainly permissible to convert after-tax IRA contributions to a Roth IRA, the conversion amount is still taxable in proportion to the amount of total combined IRA holdings that are comprised of pre-tax contributions and tax-deferred appreciation. For example, if an IRA holder made five years of $2,000 annual non-deductible IRA contributions in the 1990s ($10,000 total) and the total value of all of his IRAs (including rollover IRAs, SEPs and SIMPLE IRAs, excluding Roth IRAs) is now $500,000, if he elects to convert $10,000 to a Roth IRA, only 2% ($10,000/$500,000) of the conversion amount will be exempt from taxation.
In summary, while the concept of making non-deductible IRA contributions may be sound, the bitter pill for many tax-payers may be double taxation on the money they have contributed. It could potentially take decades to get ones after-tax money returned and the odds of beneficiaries who may eventually inherit the residual IRA avoiding the taxation on the original contributions are slim to none. For further reading on this subject, see the following article links:
-Forgot to File Form 8606 for Non-Deductible IRAs? (About.com)
-Deductible Versus Nondeductible IRA Contributions (Kiplinger’s)
-How Do I Handle My Nondeductible IRA When I Turn 70.5? (Zacks Research)
-Non-Deductable IRA Rules (Zacks Research)
-How to Find Old Non-Deductible IRA Contributions (Zacks Research)
The information in this post has been obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. Neither Financial Planning Hawaii nor JW Cole provides specific tax or legal advice and nothing contained in this post should be construed as such. All readers of this post are urged to consult with their tax and/or legal advisor(s) before taking any action pertaining to issues discussed herein.