Non-Deductible IRA Contributions Could Leave You Taxed Twice

Investing, IRA, Taxes
Senior man being puzzled with tax documents

By J.R. Robinson

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If you’re ineligible to make tax-deductible contributions to a traditional IRA, and you make too much money to contribute to a Roth IRA, you have another option: making non-deductible (that is, after-tax) contributions to a traditional IRA. It seems like a smart decision: Why not take advantage of the government’s offer to let your contributions grow tax-deferred until withdrawal many years in the future? The problem is, you could end up paying taxes twice on some of the money you contribute — especially if you neglect to file a tax form that you might not even know exists.

With all traditional IRAs, you can begin making withdrawals, or distributions, at age 59½ — and once you reach 70½, you’re required to take distributions if you haven’t yet started them (see IRS Publication 590). Your IRA custodian (the bank, brokerage or other institution where you have the account) reports the full amount of the distribution to the IRS using Form 1099-R.

In theory, you will owe federal income tax only on the portion of the distribution that is attributable to tax-deferred growth, while the portion attributable to after-tax contributions would not be taxed.

In practice, for many who have made non-deductible IRA contributions, your reward for saving 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. You’re supposed to report those contributions to the IRS yourself using Form 8606, which you file with your tax return for each year in which you made non-deductible contributions. The trouble is that many taxpayers — particularly those who prepare their own returns — are unaware of this form. Without 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.

Even for those who were savvy enough to file Form 8606 and who have maintained meticulous records of after-tax contributions, teasing out your after-tax contributions is still not as simple as you would think.

Many investors mistakenly believe that, as long as they have maintained their non-deductible IRAs separate from their pre-tax 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. For example, if they made $25,000 in after-tax contributions to an account now worth $100,000, they assume that only three-quarters of their distributions from that account would be taxable.

In reality, however, the IRS requires you to consider the after-tax contributions in relation to the total value of all IRAs you own. For investors with considerable IRA holdings, this often means that only a very small percentage of the distributions from a non-deductible IRA may be 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, my friends — 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.

For example, say 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, but 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, or $200, will be exempt from taxation.

In summary, while the concept of making non-deductible IRA contributions may be sound, the bitter pill for many taxpayers may be double taxation on the money they have contributed. It could potentially take decades to get the 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.

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