Non-Deductible IRA Contribution

In yesterday’s post, I discussed when a traditional IRA contribution is non-deductible. So what happens if you make a contribution, but you don’t qualify for a deduction? Good question. Let’s look at the consequences, and assess the pros and cons.

First, the amount of your non-deductible contribution will—eventually—come back to you tax-free, unlike investment earnings within the IRA or deductible contributions. That’s fair. After all, if your $5,000 contribution isn’t deducted today, but it’s taxed to you in the future, that would amount to an unfair double tax on the same dollars.

What gets tricky is determining exactly when the $5,000 comes back tax free. It doesn’t happen all at once. Rather, a pro-rata portion of each distribution is treated as tax-free. Here’s a f’rinstance. Say you make a $5,000 non-deductible contribution and that’s your only one. Years later, when you begin taking distributions, the IRA has grown with investment earnings and other additions to $200,000. Let’s say you then take a $10,000 distribution. Since your non-deductible contributions ($5,000) amounts to 2.5% of the IRA’s value, 2.5% of the $10,000 distribution is tax-free. That’s $250 tax-free and $9,750 taxable. You still have $4,750 to recover tax-free with future years’ distributions.

Here’s a detail to keep in mind. Even though the $250 is tax-free it still counts toward meeting your Required Minimum Distribution obligation if you had already reached age 70-1/2.

This whole pro-rata thing sounds complicated. You might ask yourself how in the world you’re going to keep track of these non-deductible contributions when you might not be planning on distributions for another 30 years. (And you can’t even remember where you keep the beach umbrella from one summer to the next!) Well, it turns out the administrative part of the whole thing is not too bad. The IRS makes you file a form when you make a non-deductible IRA contribution (Form 8606). And that form serves the useful functions of keeping track of all your past non-deductible contributions, figuring out the how much of a distribution is tax-free, and carrying over the remainder to the following year. So you only have to find your most recent Form 8606. You, Turbo-Tax or your accountant can certainly handle that.

Is a non-deductible IRA contribution worth it? That depends on many factors, primarily your years to retirement, your investment plan, and your tax bracket. Here’s an example. Margie is age 40 and plans to retire at age 65. She has $5,000 to add to her savings, and her choice is between a taxable investment account and a non-deductible IRA. Using some reasonable assumptions, she projects that the $5,000 will net her, after tax, annual retirement spending of $638.09 if it is invested in a taxable account, and $693.78 if it is invested in a non-deductible IRA. That’s a 9% increase. But if she were instead age 50, the same assumptions would lead her to project a 2% increase; and if she were age 60, a 1% decrease in after-tax spending. So, like so many things, the answer is: "It depends."