Non-Deductible IRAs

A friend recently asked me a question about non-deductible IRAs. She had been putting money into non-deductible IRAs for years and realized she had not reported the deposits to the IRS. Her question “What should I do?”

First, what are non-deductible IRAs?

If you have a job, you can put aside up to $5,000 into an IRA ($6,000 if you are over 50) or the amount of your compensation, whichever is lower. In other words, if you work part time and earn $2,000 then you can put up to $2000 into your IRA. (I’m sure Bill Gates earns more than $5,000 a year so he can put aside ONLY $5,000. Does anyone know if he is over 50?)

If you decide to put money into an IRA, you have to figure out if you can deduct it on your federal income tax return. The first question you need to answer is: “Do you participate in a retirement plan of some sort?” If so, there are income limits that determine whether or not you can deduct the IRA contribution. A married couple filing a joint return can deduct an IRA if their total income is less than $89,000. It cannot be deducted if their income exceeds $109,000. There is a phase-out of how much you can deduct between those two numbers. If your total income is $99,000, you can deduct up to $2,500.

The income-limits for single individuals are $55,000 and $65,000.

You have a non-deductible IRA if you contribute to an IRA, you are in a pension plan, and your total income exceeds $109,000 (if married) or $65,000 (if single).

So you put the money aside, but did not get any tax benefit.

Why would you do this? The investment earnings on the IRA are not taxed in the year they are earned. So you get to accumulate the earnings until you decide to withdraw money from your IRA, possibly when you are not working and in a lower tax bracket.

Eventually, you will withdraw money from the non-deductible IRA. You should pay tax only on the earnings, but not on the money you contributed because you did not get a tax benefit when you made the contribution.

There is a horrendous calculation you need to make when you withdraw money from the IRA. You must calculate the portion of the withdrawal that came from investment earnings and pay tax on it. You do not want to pay tax on the contributions you made. The various tax packages do a good job of making this calculation. Don’t try doing it on the back of an envelope.

This is where my friend’s question comes in. You are supposed to tell the IRS when you put money into a non-deductible IRA. You do this every year on Form 8606. Then each year you add the current year’s contribution to the total of the prior contributions and have all the information at your finger tips. She did not do this.

What she needs to do is go back and total up all the non-deductible contributions that she made. She should not include any income earned in the calculation and she should not include any contributions to ROTH IRAs. It is possible that she can get the information from her mutual fund company. Form 8606 should be completed when she does her 2009 tax return. Line 1 is for her 2009 non-deductible contributions. She should put the total of the non- deductible IRA contributions from all the prior years on Line 2 of that form. A total goes on line 3. Then, going forward, each year Form 8606 should be filed with her tax return.

The IRS will probably not question the change but be prepared to provide the calculation should they become interested. There is a potential annual $50 penalty for not filing Form 8606.