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Helping Heroes Retire

Helping Heroes Retire

IRA’s and Roth IRA’s – Tax Pitfalls You Need to be Aware of

Posted on July 12, 2021 by Gregg Brant

by Gregg Brant

Many clients come to us not knowing that they CANNOT contribute to an Individual Retirement Account (IRA) and receive a tax deduction because they participate in an employer-sponsored retirement plan (yes, that means all of you with defined benefit pensions and FRS Investment are included). If you participate in your employer’s plan or if you are above the income threshold (presently $66,000 for single filers and $105,000 for married couples), then you are ineligible to make DEDUCTIBLE IRA contributions. You are still permitted to make nondeductible IRA contributions.  

Does it really make sense to fund an IRA with nondeductible contributions?  

Nondeductible vs. Deductible Contributions: 

Nondeductible contributions to a traditional IRA are subject to the same contribution limits as deductible IRA contributions. You can contribute up to $6,000 in 2021, or $7,000 if you are over the age of 50. 

Contributions to deductible traditional IRAs are made with before-tax (pre-tax) dollars. You can claim a tax deduction for the current calendar year or the prior calendar year through April 15th (tax filing deadline. These contributions grow tax-deferred, and you do not pay taxes on that money until you withdraw the funds. All withdrawals or distributions are treated as ordinary income for tax purposes when you make a withdrawal. 

Nondeductible IRA contributions use after-tax dollars. You cannot deduct them on your tax return. They are not taxed when you withdraw the money, provided you do not withdraw more than your original basis (what you put into the IRA) and that the basis is tracked annually on Form 8606 (yes, that means if you made a nondeductible contribution 20 years ago, you would have to track it each year to receive this benefit). Note: The Basis also does not grow as your investments grow. Any additional withdrawals are taxed at your marginal tax rate. 

Roth IRA contributions are also made with after-tax dollars. You do not get a tax deduction for them, but you can take qualified distributions from these accounts without paying any further income taxes. All growth of these assets is tax-free. Roth IRA accounts must be open for 5 years to take a qualified withdrawal which can include your basis in the IRA prior to age 59 1/2 (allowing it to serve as both a savings account and retirement savings vehicle).  

So, you are given the option of having all your money grow tax-free in a Roth-IRA vs. Making Non-Deductible IRA contributions and only receiving a return of your basis or the principal you contributed, which do you think is better? 

How to Report on Your Taxes: 

You must file Form 8606 to report nondeductible IRA contributions. This form creates your “basis” in the IRA. You can make both deductible and nondeductible contributions to a traditional IRA, but only your basis can be withdrawn tax-free (not the growth). You are required to file this form each year you contribute to your IRA.  The most common mistake we find is clients forgetting to complete Form 8606 along with the tax return, but you could report the contributions in arrears if you made the nondeductible contributions and failed to report your basis information. 

Correcting Non-Deductible Contributions: 

You can make a nondeductible IRA contribution each year, then convert it to a Roth IRA using the backdoor Roth IRA approach. You will pay taxes on any converted amount that is above your basis at the time you convert. You also will only pay the 10% early distribution penalty on any tax withheld from the amount converted. For example, if you invest $6,000 into your nondeductible IRA and it grows to $10,000 and then you convert the full amount from your IRA to your Roth IRA, you will only pay taxes on the $4,000 of growth. If you withhold 20% from the amount converted ($2,000) to cover the tax liability, you will be hit with a $200 early distribution penalty (10% of the $2,000 withheld). It is almost always advisable to pay the taxes from another source (your bank savings or earnings) to maximize the value of the Roth conversion amount. 

Your basis for your Roth conversion must be calculated using a pro-rata formula if you have other IRA accounts.  For example, suppose you have $12,000 in a traditional IRA. You make a $6,000 nondeductible contribution to a separate IRA account. You now have a total of $18,000 in two IRAs. One-third of that amount is nondeductible, and the other two-thirds are deductible or taxable. You cannot convert just the nondeductible IRA portion. The IRS looks at all your IRA accounts combined. So, one-third of the converted amount (about $2,000) would be considered the basis, and the other two-thirds (about $4,000) would be considered taxable income in the year of the conversion if you were to convert just $6,000. The IRS does not include any pre-tax investments in employer-sponsored retirement vehicles (401(k) or 457(b) plans) to determine the nondeductible portion; only IRA accounts are taken into consideration. 

In most cases, we highly recommend converting all non-deductible IRA contributions to a Roth IRA so that all future growth is tax-free. Doing so also makes tracking basis much easier, as all qualified distributions from your Roth IRA will be tax-free (even the growth of the assets) – so you benefit more from the tax-free compound growth of your assets AND do not have to file an extra tax form each year! 

This strategy can help maximize your retirement income and assets while minimizing your future tax liabilities 

Please contact our office if you would like assistance reviewing your non-deductible IRA contributions and correcting them – or if you would like a review to ensure that you are maximizing the tax efficiency of your retirement plan! 

Gregg Brant, CFP®, APMA®, MBA

Family Wealth Advisor | Contributor

Gregg is a financial planner who is passionate about helping first responders and their families navigate their financial lives with confidence. Having a spouse who is a professor in the State University System, Gregg has worked with the Florida Retirement System first-hand for his own personal financial planning.

Now Gregg is on a mission to take this knowledge and disseminate it to the people who deserve it most; our first responders.