Non-deductible IRA contribution

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Xan
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Non-deductible IRA contribution

Post by Xan » Mon Dec 11, 2017 1:25 pm

So I had always understood the income limits on being able to do Roth contributions, but that there was no such limit on traditional IRA contributions.

It turns out that's not true... In some circumstances, there are limits. For example, spousal IRA contributions have an income limit.

Crucially, I believe that these limits are DEDUCTION limits, not CONTRIBUTION limits. That is, the only result of my screw-up is that my deduction for the contribution was disallowed. I don't believe I need to get the money out using the "accidental over-contribution" method, or face huge penalties. Does that sound right to everyone?

So then, my options are to take the money back out, incurring an instant 10% penalty, or to leave it in. If I leave it in, will I then have to pay taxes when I take the money back out? The same money I've already paid taxes on? Or will I only owe on the growth? I'm assuming it's only the growth, right; they couldn't expect just to double-tax like that... Right?

If it IS only the growth, then I have to keep track of this situation for the next several decades... What a pain.
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Re: Non-deductible IRA contribution

Post by Cortopassi » Mon Dec 11, 2017 2:36 pm

As I understand it and I have seen for myself, my wife, who does not work and therefore isn't covered by a retirement plan, always gets it fully deducted. For me, since I am covered by a 401k plan, it depends on my income.

Non deductible portions raise your basis in the IRA, so you'd only pay taxes on the growth.
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Re: Non-deductible IRA contribution

Post by Xan » Mon Dec 11, 2017 3:28 pm

Thanks, Cortopassi. You might want to double-check that about the spousal IRA, because there IS an income limit, and it's pretty similar to the income limit for you as an earner covered by another plan. There's a phase-out, and it's gone completely before you hit $200k.

You're right about the cost basis. I've been pointed to Form 8606, which apparently is how this kind of thing is kept track of. I'll now be filing Form 8606 each year for the rest of my life.
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Re: Non-deductible IRA contribution

Post by Xan » Mon Dec 11, 2017 3:44 pm

It was for 2016. Filed at the extended deadline (for the first time ever) because we were moving in April and everything was crazy, so I only just found out about this.

Still, the growth will be tax-free... Is it worth contributing to an IRA even without being able to deduct the contribution?
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Re: Non-deductible IRA contribution

Post by Cortopassi » Mon Dec 11, 2017 3:51 pm

Xan wrote:Thanks, Cortopassi. You might want to double-check that about the spousal IRA, because there IS an income limit, and it's pretty similar to the income limit for you as an earner covered by another plan. There's a phase-out, and it's gone completely before you hit $200k.

You're right about the cost basis. I've been pointed to Form 8606, which apparently is how this kind of thing is kept track of. I'll now be filing Form 8606 each year for the rest of my life.
You are right. Looks like the spouse one starts getting limited when income >186k. Not a worry at this point... ;D
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Re: Non-deductible IRA contribution

Post by WiseOne » Mon Dec 11, 2017 9:32 pm

Xan, if you don't have deductible contributions already sitting in an IRA, you could just turn this into a backdoor Roth contribution.

Otherwise yes, my understanding is that you can either undo the contribution ("recharacterization") or file form 8606 annually to report your tax basis in the IRA. You'll be taxed on earnings (at ordinary income tax rates) but not on the basis.

This is likely to be a bad deal compared to paying capital gains rates on the gains from the same investment in taxable. Theoretically, it's better to keep the money in the IRA because you'd otherwise have to pay taxes on any realized income from it along the way, which will slow its growth. In practice, if you invest it in something and leave it alone, interim income (dividends etc) will be minimal. I'd only leave it in the IRA if you intend to invest it in interest-paying instruments, which would be taxed at ordinary income rates anyway.
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Re: Non-deductible IRA contribution

Post by Xan » Wed Dec 13, 2017 12:42 pm

The backdoor Roth contribution was exactly the right thing. Thanks WiseOne!
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Re: Non-deductible IRA contribution

Post by ochotona » Wed Dec 13, 2017 7:41 pm

Beware of this rule

The Pro-Rata Rule

All rollovers from Traditional to Roth IRAs must be done on a pro-rata basis. So if you have existing Traditional assets (pre-tax) and you try to do a Backdoor Roth IRA by contributing to a non-deductible Traditional IRA (post-tax), you cannot choose to only rollover the non-deductible Traditional assets. Instead, any amount you rollover will be taken proportionally from across all of your Traditional assets. For example, if you have $90k in deductible contributions and you make $10k in non-deductible contributions, intending to immediately roll it over to a Roth, when you do the $10k Traditional to Roth conversion (10% of your total Traditional assets) you will actually be converting $9k from your deductible contributions (10% of $90k) and $1k from your non-deductible contributions (10% of $10k).
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Re: Non-deductible IRA contribution

Post by Xan » Wed Dec 13, 2017 8:30 pm

Thanks, ocho.

Fortunately I don't actually have any other money in the Trad IRA at the moment. So this is about as clean of a maneuver as it can be.
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Re: Non-deductible IRA contribution

Post by WiseOne » Thu Dec 14, 2017 6:26 am

Glad that worked for you Xan!

This is the single best reason to open a solo 401K instead of using an IRA to get money out of old employer retirement accounts. Keeping IRAs empty except for nondeductible contributions destined for a Roth is the way to go if you're above the income limit for Roth contributions.

I notice that the backdoor Roth loophole is apparently going to survive the current round of tax reform.
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