High income families faced with high annual taxes are often looking for ways to reduce their taxes or save additional dollars in tax-efficient ways. Unfortunately, these well-intentioned pursuits often result in irrational behaviors (such as permitting the government to shortchange your retirement savings) or unfavorable outcomes (such as paying more taxes than you would have otherwise paid by doing nothing). Among the classic examples of generally ill-advised tax-saving strategies are non-deductible IRA contributions.
What is a Non-Deductible IRA Contribution?
Different rules apply for making deductible IRA contributions depending on marriage status, income, and eligibility for a workplace retirement plan. Individuals not covered by a workplace retirement plan or married couples where neither spouse is covered by a workplace plan are eligible to make IRA contributions, regardless of income. Alternatively, a husband and a wife who are both covered at work by retirement plans cannot make deductible IRA contributions if their combined income exceeds $118,000 (2016). The full set of deductible contribution limits can be found here.
Many successful working professionals eventually become disqualified to make deductible IRA contributions as their income grows. Despite pervasive public belief to the contrary, this is not the end of the road for IRA contributions. The IRA deduction rules merely limit the ability of individuals to make deductible IRA contributions – they do not prevent individuals from making non-deductible IRA contributions. In fact, any working individual or spouse of a working individual, regardless of income or availability of a workplace retirement plan, is eligible to make non-deductible IRA contributions.
The basic idea of a traditional IRA is that you make contributions each year which can then be deducted from income and resultantly reduce your tax liability. The tax is avoided upfront but paid in the future – ideally after many years of tax-deferred growth.
So if the benefit of a traditional IRA contribution is the immediate tax deduction, then why would someone contribute after-tax dollars to an IRA without any deduction? There are generally two viable reasons to make non-deductible IRA contributions. First, the individual may be a prime candidate for the backdoor Roth conversion – the initial step of which is the non-deductible IRA contribution. The second reason someone may be inclined to make non-deductible IRA contributions is that any growth or income that accrues inside the IRA after the contribution is tax-deferred and only taxed whenever distributions begin in the future.
What Are the Drawbacks of Non-Deductible IRA Contributions?
Given the potential benefit of deferred taxation, non-deductible IRA contribution may seem to be an underutilized opportunity. However, there are a number of potential drawbacks that tend to make these contributions only useful for short-term traders.
1) Favorable capital gain tax rates instead become less favorable ordinary income tax rates. It’s important to understand that non-deductible IRAs do not eliminate taxes on gains – they merely defer taxes. In many cases, simply buying an index fund in a regular brokerage account can be far more tax efficient than buying the same fund in a non-deductible IRA.
Consider the scenario where you contributed $5,500 to a non-deductible IRA, invested in a stock fund, and the investment grew over the past 25 years at 8% per year. You’re now ready to liquidate the IRA – all $37,667. Because of other income sources and Social Security, you find yourself in the 28% federal tax rate which means paying taxes of $9,007 on the distribution[i]. Had you made the same investment in a regular brokerage account, you would be paying long-term capital gain taxes at 15% which translates to $4,825 of taxes – nearly half of what you had to pay with the IRA.
If you’re planning to day-trade the investments or do a lot of trading and would not likely achieve the minimum 1-year holding period to qualify for long-term capital gain rates, then the deductible IRA would be a better choice. Otherwise, the premise that the non-deductible IRA will save taxes over the long-run may be ill-conceived.
2) You face forced taxable distributions in the future. Even if you had not needed to liquidate the IRA account in the example above, the IRS would have forced you to start taking mandatory distributions beginning at age 70.5 and every year, thereafter. Each of these distributions would again be taxable as the less favorable ordinary income rates. In contrast, the regular brokerage account imposes no forced distributions so investments can be left to grow tax deferred until the funds are needed.
3) You lose the potential step-up in basis. Continue with the same example and assume that you never needed to use the proceeds from the hypothetical investment account. At death, the IRA would still be taxable as ordinary income to your beneficiaries at their then-current tax rate. In contrast, the regular brokerage account gets a favorable “step-up in basis” at death meaning that your beneficiaries could sell the appreciated investments and owe zero taxes. The non-deductible IRA contribution converted $32k of gains into ordinary income and $9k of taxes that could have entirely been avoided.
4) There’s a good chance you pay taxes on the same dollars, twice. In the world of fallible human beings, the best action is often not the economically optimal option. That is, practical considerations matter and often matter a lot. Someone could evaluate the tax benefits of making non-deductible IRA contributions and determine that they are economically optimal based on the individual circumstances. Yet this still does not mean the IRA contributions are the best course of action.
When you make a non-deductible IRA contribution, the IRS expects that you file a Form 8606 not only in the year of the contribution but every year, thereafter. This form tracks your IRA basis so that when it comes to distribute from the IRA, you’re not paying taxes on the same dollars twice. In the real world, many people lose track of filing this form. Maybe they switched to a new accountant or to new tax software and Form 8606 stopped getting filed. Forgotten IRA basis is even more likely when the IRA owner dies. Although beneficiaries are able to avoid tax on any inherited IRA basis, this information almost never gets communicated from the executor to the beneficiaries. The next time a new client brings in an inherited IRA and knows the basis or received the Form 8606 from the executor will be the first time.
All of this simply means that a large amount of non-deductible IRA contributions are being taxed twice – once at the time of the contribution (since the contribution is made with after-tax dollars) and then at the time of the distribution (since without a record of basis, all distributions are assumed to be taxable). Speaking from experience, we would bet that more IRA basis is ultimately lost and taxed twice than the amount properly recorded and taxed just once. This likelihood of double taxation is another real-world drawback of the non-deductible IRA contribution as it contradicts with the initial objective of reducing taxes.
Experience suggests that many high income earners start by looking for perceived tax-efficient saving vehicles like 401(k) plans, non-deductible IRAs, or tax deferred annuities and then fill up those buckets without really examining the ultimate tax efficiency of the entire retirement savings strategy. We suggest a better approach is starting not with the solutions but with the question “how much do I need or want to save for retirement this year?” Only after first addressing that question does it make sense to then evaluate the implementation. In many cases, investors will find that the perception of tax savings from strategies like the non-deductible IRA contribution are really just perceptions that get in the way of a useful big picture retirement strategy.
[i] The initial $5,500 non-deductible IRA contribution in this scenario does not get taxed – only the gains of $32,167.