In my previous blog I described some of the rules surrounding making and deducting IRA contributions. If you are over the IRS income thresholds, you can still make the IRA contribution, you just won’t be able to deduct it on your taxes – the contribution would be made with after-tax dollars. This is where tax form 8606 comes into play.
What is Tax Form 8606?
You are required to file Form 8606 when you make a non-deductible IRA contribution; this tax form will document the contribution amount for the current year. It must also be filed with your taxes when you withdraw funds from an IRA in which non-deductible contributions were made. If you don’t file this important tax form, when you go to withdraw funds you’ll face tax consequences. Any amount you contributed that did not receive a tax deduction (after-tax dollar contributions) will be treated as if it did, in fact, receive a tax-deduction and you will be taxed AGAIN on the money. If you do file form 8606 properly, when you go to take a distribution, a portion will be taxable (any earnings) and a portion will not (return of original after-tax contribution).
Is your head spinning yet? Things get confusing quickly and mistakes can happen VERY easily when making non-deductible IRA contributions. Those mistakes could potentially result in double taxation of contributions that could cost investors substantial amounts of money over the course of their retirement. Not many people want to deal with tracking contributions over the course of a career and will elect to not make non-deductible IRA contributions because of the potential administrative nightmare it can create.
Non-deductible IRA Alternatives
So what else is there if you have additional funds to invest beyond maxing out a company retirement plan? If your income is within the IRS limits, you could consider contributing to a Roth IRA. As with a non-deductible IRA, contributions are made with after-tax dollars. However, all withdrawals, including earnings are not taxable if a qualified distribution occurs. If income is too high for Roth contributions, you still might be able to contribute by utilizing the “back door” conversion strategy. If you are phased out from the Roth because of your high income (a good problem to have!) and you don’t fit the mold for a Roth conversion, you could consider opening a taxable brokerage account. Those funds would not grow tax-deferred, but withdrawals would not be included in ordinary income like an IRA because you never received a tax deduction on the contributions.
As you can see, there are many subtle nuances of different types of retirement and investment accounts. Your planner can help you identify which accounts make the most sense for you based on your current and projected financial situation. Working with someone you trust thoroughly to help you make these decisions is imperative and is something we deeply care about at The Center.
Nick Defenthaler, CFP® is a Support Associate at Center for Financial Planning, Inc. Nick currently assists Center planners and clients, and is a contributor to Money Centered and Center Connections.
The information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc. and not necessarily those of Raymond James. Unless certain criteria are met, Roth IRA owners must be 59 ½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Converting a traditional IRA into a Roth IRA has tax implications. Changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. As Financial Advisors of RJFS, we are not qualified to render advice on tax matters. You should discuss tax matters with the appropriate professional. C14-009867