I hate to see people pay taxes twice, but it happens more often than you might think.
We see this most often among new clients who overlook the tax on non-deductible IRA contributions and their growth.
When we work with clients, especially new ones, we like to review their tax returns. A tax return tells us a lot about someone: 1) How many after-tax accounts they have, 2) If they are charitably inclined, and 3) What deductions they take. One of the sections we always check is Form 8606. This form tells us if they have non-deductible money (basis) in their IRA, which we consider to be a huge red-flag.
Why is it concerning to have non-deductible money in your IRA? For one, we prefer our clients to have the contribution basis in a Roth IRA so all future growth is tax-free. In addition, individuals risk paying taxes on their basis twice at some point in the future if they keep the non-deductible basis in their IRA. In this article, we will outline the basics regarding traditional deductible IRA contributions and non-deductible IRA contributions, their corresponding tax implications, and how an in-depth understanding of how to navigate their tax discrepancies can help you avoid leaving money on the table as you save for retirement.
How do you get non-deductible money (basis) in your IRA?
We often work with our Shell, Chevron, Marathon Oil, and BMC clients to help them understand why they have non-deductible basis in their IRAs, and what they can do to mediate the tax risk they face as a result.
Let’s say you are a successful professional or executive in the Houston area. You are a saver. After paying your necessary expenses, you put all the money you can aside to prepare for retirement. After maxing out the pre-tax contribution on your company’s 401(k) plan, you resort to putting your extra funds in an IRA in an attempt to sock additional dollars away for your golden years. The dilemma here is that your household income is too high to contribute to a deductible IRA, so the $13,000 IRA contribution you made for you and your spouse ($6,500 each) ends up being non-deductible.
Suddenly, ten years have passed and you now have over $100,000 of basis in your IRA. You are a natural saver and have been diligent about setting your extra money aside for retirement. That’s great! However, without careful planning, you may pay taxes on the contributed funds twice. Why? Let’s first review how traditional deductible IRA contributions work before diving into the complexities of a non-deductible IRA contribution.
How do traditional deductible IRA contributions work?
A traditional IRA has two primary advantages: 1) Tax-deductible contributions on the entire contribution amount as long as you’re not covered by an employer’s retirement plan and over the income limit, 2) Earnings on the contribution’s growth are tax-deferred. When you make a deductible IRA contribution, you receive a tax deduction for the money you contributed, effectively making this a pre-tax contribution. The contribution funds grow tax-deferred while in the IRA, but you will be subject to paying taxes on the growth upon making withdrawals throughout retirement.
For example, consider that your household income is only $100,000 and you qualify for an IRA deduction. You and your spouse (both age 50 or over) each contribute $6,500 to an IRA ($13,000 total). You are able to deduct the $13,000 from your taxes. For your tax-return, your $100,000 household income went down by $13,000 and is now only $87,000. The $13,000 contribution to your deductible IRAs effectively reduces your taxable income by $13,000!
How do non-deductible IRA contributions work?
Non-deductible IRA contributions work a bit differently and are often the result of the contributor’s household income being too high, thus exceeding the IRA deduction limits. For example, if you’re married and your income is over $101,000 --$63,000 for individuals-- your IRA contribution is not fully deductible. You can always contribute to an IRA, but you cannot receive a deduction for the (entire) contribution, thus the funds are treated like after-tax money.
How are non-deductible IRA contributions taxed when withdrawn?
With a non-deductible IRA contribution, you are putting after-tax money into an IRA and any growth on the contribution is still tax-deferred. When you eventually withdraw from your IRA, the contribution will come out tax-free, but you will have to pay taxes on the growth. At least that’s how it works, in theory, assuming you have handled the administration of tax Form 8606 each and every year!
The dilemma with IRAs is that unlike your company’s 401(k) plan, YOU are in charge of tracking the source (in this case the basis) of all non-deductible contributions. You must record current and historical contributions each and every year on Form 8606 of your tax return. This form shows the IRS the amount of after-tax (non-deductible) contributions you’ve made each year, and without it, your IRA basis will be taxed AGAIN when you withdraw the funds in retirement. Essentially, if you miss one year, you may find yourself paying twice the taxes in another. Note: This is your job to track, not your custodian’s.
What should you do when you have non-deductible basis in your IRA?
We had this exact issue arise with a Shell Oil executive we recently on boarded to our firm. As part of our comprehensive planning process, we reviewed his tax return and noticed there was an $89,000 basis of non-deductible IRA contributions, with another $42,000 in his spouse’s IRA. The total value of his individual IRA was a little over $300,000. That’s $211,000 of taxable growth over time on the initial contribution of $89,000! So, how can he avoid paying taxes on both the contribution ($89,000) and the growth ($211,000) in retirement?
The solution we used for this client’s situation was to roll the growth into a 401(k) plan and convert the basis into a Roth IRA account via a Roth conversion.
One of the benefits at Shell Oil is that their 401(k) plan, the Shell Provident Fund, accepts incoming rollovers. This means that we can roll the $211,000 of growth into the Shell Provident Fund, so that the earnings are held in the client’s 401(k). This strategy reduces the client’s basis held in his IRA to $89,000 of non-deductible after-tax money. Since the entirety of the money left in his IRA is non-deductible (after-tax money), we then used a Roth Conversion to move the non-deductible money from his IRA to a Roth IRA, which is funded by after-tax income contributions and allows the growth to be withdrawn tax-free.
Whereas before, the client would have paid on the initial contribution of $89,000 to his IRA AND the contribution’s earnings, he can now withdraw the contribution and its earnings without being subject additional taxes beyond the initial contribution tax already applied. In other words, he will only pay taxes the non-deductible IRA contribution one time.
What are the benefits of your IRA contribution basis being in a Roth IRA?
Assuming you follow this strategy, you will no longer be required to track your IRA contribution basis on Form 8606 after the 2018 tax year, meaning you will not be at risk for being taxed twice. What’s even more exciting is that any future growth from the $89,000 basis will never be taxed in a Roth IRA! Tax-free growth for life!
If you currently have non-deductible funds in an IRA, you may want to consider speaking with your financial advisor about what you can do to avoid paying more taxes that you have to. However, you should first make sure your financial advisor isn’t giving you conflicted advice. Too often, do I see “advisors” recommending clients NOT to roll the pre-tax into the 401(k) and the basis into the Roth IRA, solely so they can continue managing --and billing on-- the client’s IRA! This advice is likely in the advisor’s best interest, not yours!
Note: there are situations when rolling pre-tax money to a 401(k) isn’t the right fit, such as when there are limited investment options, or when expenses are really high in the 401(k). However, such situations are becoming increasingly rare.
If you would like more information regarding how to handle non-deductible basis already in your IRA, take advantage of our free, 90 min consultation. During this meeting, a WJA financial professional will take an in-depth look into where you are today, where you want to be tomorrow, and how you can use strategic financial planning to reach your retirement goals.