The After-Tax Contributions You Should Be Making
The annual contribution limit to all of your traditional and Roth IRAs for 2019 is $6,000, or $7,000 if you’re age 50 or older.
Your traditional IRA contributions may be tax-deductible. The concept being that you deduct contributions during your high-tax-rate years, let them grow tax-deferred, and withdraw them when your tax rate is lower.
However, the deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels.
The amount you can put into a Roth IRA has its own limitations, regardless of whether or not you have a qualified retirement plan…
If you find that that you can’t contribute to a traditional or Roth IRA, the IRS still lets you make after-tax contributions to a…
A non-deductible IRA is very similar to a traditional IRA. The contribution limits are the same … $6,000, or $7,000 if you’re age 50 or older.
The big difference, as the name implies, is that you don’t receive a tax deduction for the money you contribute.
But the investments in the account grow tax-deferred until you withdraw them. Part of those withdrawals will be tax-free because they are a return of principal. The growth portion is fully taxable.
How much to pay in taxes can be a little tricky…
For example, suppose you contributed $7,000 a year to a non-deductible IRA for 15 years beginning at age 50, retire at age 65, and start taking distributions. At a 6% annual return, the account would be worth $163,000.
You might think that you’ll withdraw $5,000 and call it a tax-free return of principal.
Sorry, you can’t pick which dollars you take out.
The IRS requires that you add all of your IRAs together when calculating the tax liability.
Assuming the total value of your IRAs is $300,000 you would divide your basis, $105,000 ($7,000 x 15) by $300,000 and get a ratio of $105,000 ÷ $300,000 = 35%.
So about 35% of your first withdraw will be a tax-free return of your contributions. In other words, take out $5,000 and you’ll receive $1,750 tax-free with the balance ($3,250) fully taxable at your ordinary tax rate.
However, no matter how much you earn you could use a backdoor Roth conversion to avoid future income taxes altogether.
Here’s how this strategy works:
Soon after you fund a non-deductible IRA convert those funds to a Roth IRA where earnings grow tax-free rather than tax-deferred. Plus you won’t have to bother with pesky required minimum distributions (RMDs).
Funding a non-deductible IRA is more than simply sending a check to the custodian.
You’ll have to:
- Track your cost basis (the amount you contribute) or setup a separate account to avoid accidentally paying income taxes twice on your non-deductible contributions.
- File form 8606 when making contributions and withdrawals. It’s the only way the IRS will know that you’re putting after-tax money into an IRA. Without this form, the IRS will expect you to pay taxes on the entire distribution instead of only the gains.
Keep In Mind
Like most investing strategies a non-deductible IRA isn’t the right move for everyone. Compare it to a fully-taxable brokerage account.
True, a non-deductible IRA could grow faster because all earnings and growth are tax-deferred. But the ultimate tax could be higher because you’ll pay at your ordinary tax rate (10%-37%).
Whereas with a regular brokerage account you might be eligible for the lower long-term capital gains rate (0%-20%). The same goes for qualified dividends, which are taxed like capital gains instead of ordinary income.
What’s more, an IRA — whether deductible or non-deductible — does not get a step-up in basis for your beneficiaries. But a taxable account does. So if IRAs will make up a significant portion of your estate, you might want to avoid increasing that liability even more with after-tax contributions.
When building your nest egg, contribute at least enough to your company’s qualified retirement plan to get the full employer match.
If such a plan is not available, fund a Roth IRA. But if your income makes you ineligible for a Roth, then turn to a deductible traditional IRA.
Still if you can’t fund a traditional IRA because you or your spouse has a retirement plan at work …
A non-deductible IRA is a retirement savings option of last resort.
And although it takes a bit more effort, funding a non-deductible IRA when you are ineligible for a deductible IRA and/or Roth IRA could substantially add to your retirement stash over the years.
To a richer life,
— Nilus Mattive
Editor, The Rich Life Roadmap