Wealthier individuals should be rushing to their bank to make a
non-deductible IRA contribution. This is certainly true if they are a
This author admits his bias, many individuals should be making
non-deductible traditional IRA contributions and they don’t do so
because they (and their advisors) many times don’t understand the
benefits, including how the related tax rules apply.
Every person should contribute as much as possible to a Roth IRA. Why?
There are very few times under US income tax laws where INCOME is not
taxed. That is, no taxes are owed with respect to Roth IRA funds if the
Roth owner has met a 5-year rule and is age 59½ or older or the Roth
owner is a beneficiary who has inherited the Roth IRA and the 5-year
rule has been met.
The federal tax laws have been expressly written to make it impossible
for a person with a high income to make an annual Roth IRA contribution.
Some people (i.e. many Democrats) don’t want “wealthier”
individuals to gain the benefit of contributing funds to a Roth IRA and
earning tax-free income. They want them to pay more income taxes. A
person who had tax filing status of single was ineligible to make a 2015
Roth IRA contribution if his or her MAGI (modified adjusted gross
income) was $132,000 or more. A person who had filing status of
married filing jointly was ineligible to make a 2015 Roth IRA
contribution if the couple’s MAGI (modified adjusted gross
income) was $193,000 or more. A person who had filing status of
married filing separately was ineligible to make a 2016 Roth IRA
contribution if his or her MAGI (modified adjusted gross income was
$10,000 or more.
For discussion and illustration purposes, we will assume that Jane Doe
has the following situation. She is age 54. She is married. Her husband,
Mark Doe, is a bank president. He is age 57. Their joint income is
sufficiently high that neither one of them is eligible to make an annual
Roth IRA contribution. Their joint income is sufficiently high that
neither one of them is eligible to made a deductible traditional IRA
This article is going to discuss the question, “should these two each
make a non-deductible traditional IRA contribution?” The primary concern
is Jane’s situation, but we will also discuss Mark’s situation.
For the reasons discussed below, both should make a maximum
non-deductible traditional IRA contribution until each is no longer
eligible to make a traditional IRA contribution (i.e. the year a person
attains age 70½).
On March 15, 2016, Jane contributed $6,500 to a traditional IRA she had
established in 1984. She designated her contribution as being for 2015.
The IRA balance at the time of contribution was $8,500. With the
addition of her $6,500 contribution the IRA balance became $15,000.
Since then the account has earned $40 of interest.
It is now assumed that Jane has no other IRA funds in any traditional,
SEP or SIMPLE IRAs. The IRA taxation rules require in applying the
taxation rules that all non-Roth IRA funds be aggregated. One cannot
avoid the pro-rata taxation rule by setting up separate IRAs or having
separate time deposits.
The couple’s tax preparer has recently informed Jane that her
contribution is non-deductible as her husband participates in a 401(k)
plan and their MAGI is sufficiently high that they are not permitted to
claim any tax deduction for her $6,500 contribution. What tax options
are available to her? What options are unavailable to her?
She may not use the recharacterization rules to make her traditional
IRA contribution a Roth IRA contribution as their 2015 MAGI is too high
There is no IRS guidance allowing the IRA custodian to switch the year
for which the IRA contribution was made from 2015 to 2016
The IRS has issued rules allowing her to withdraw her 2015 IRA
contribution with no adverse tax consequences as long as she does so
by 10-15-16, no deduction is claimed on the 2015 tax return and the
related income is withdrawn. If she withdraws her $6,500 contribution
she is required to withdraw the related income and it is taxable for
2016 since the contribution was made in 2016. The related income is a
pro-rata amount of the $40 determined as follows: 6500.15000 x $40 =
$17.33. Since she is younger than age 59½ she does owe the 10%
additional tax on this $17.33. The bank as the IRA custodian will
prepare a 2016 Form 1099-R inserting the codes (81) in box 7, box 1
would show $6,517.33 and box 2a would show $17.33
In 2016 she is eligible to make a Roth IRA conversion of any amount in
the range of $.01 to $15,040. If she would convert $15,040 into her
Roth IRA she/they would include in income on their 2016 tax return the
amount of $8,540. She as many taxpayers does not want to include the
$8,540 in her/their income and pay tax on it.
Jane as many taxpayers would like to convert only her non-deductible
contribution of $6,500. This would allow her to pay no taxes since she
would not be converting any of the $8,540.
The tax rules require use of the standard pro-rata taxation rule when an
IRA has taxable funds and non-taxable funds. If she converts $6,500, a
portion would be taxable and a portion would not be. The taxable portion
is: $6,500 x $8,540/$15,040 ($3,690.82) and the non-taxable portion is
$6,500 x $65,00/15,040 ($2809.18) . Jane made a nondeductible IRA
contribution for 2015. She is required to file Form 8606 and attach to
the couple’s Form 1040. If it was not filed with the original return, an
amended tax return should be filed and the 2015 Form 8606 attached. She
is not relieved of this duty because she withdraws the $6,500 or
converts it. A $50 penalty applies to a person who fails to file Form
8606 unless she could show a reasonable cause why she did not file it. A
person must pay a $100 penalty if a person overstates the amount of
Note that Jane will also be required to file a 2016 Form 8606 regardless
if she withdraws a portion or all of the $6,500.
Having to include in income the amount of $8540 and pay tax on this
amount should not influence Jane or any other wealthy person to not make
non-deductible contributions. But it does. Tax on $8540 should not be
that material to a couple who are ineligible to make annual Roth IRA
From a practical standpoint, Jane could convert her traditional IRA over
a 2-4 year time period to lessen the amount of income which would be
taxed each year.
The best of all “planning” situations would be if Jane would either work
for an employer that had a 401(k) plan written to accept rollovers from
traditional IRAs or if she could work for the bank and become eligible
under the bank’s 401(k) plan. Why? If Jane was a participant of a 401(k)
plan, the tax rules have been so written that if she wants to make a
rollover contribution, the amount rolled over “first” is the taxable
portion. The prorate rule does not apply in this situation.
If Jane only rolls over $8,540, this means that the $6,500 remaining in
the IRA are non-taxable. She may then convert such amount to a Roth IRA.
This is her goal, this any person’s goal.
In summary, Jane wants to make as make non-deductible IRA contributions (currently
$6,500 but his amount which change as it is indexed for inflation)
as she can between ages 54-701/2 because she should convert all such
funds into a Roth IRA.
What about her husband, Mark? He too wants to make the maximum amount of
nondeductible IRA contributions from ages 57-70½ and at some point
convert such contributions to a Roth IRA. The sooner the conversion can
be completed the better as the earnings realized after the conversion
will be tax-free if the qualified distribution rules are met.
Most likely Mark participates in a 40(k) plan which will allow him to
move “taxable” IRA money into his 401(k) account. If not, he probably
has the ability to rewrite the plan so he would have this right.
The 401(k) plan in which he participates may allow him to make
Designated Roth deferrals and he exercises that right to the maximum.
This would be $24,000 for 2016 ($18,000 + $6,000). Good for him. But why
not contribute an additional $6,500 to his traditional IRA as a
non-deductible contribution and convert it? Contributing $6500 for 12
years would result in an additional $78,000 in a Roth IRA.
In summary, Mark too should want to make as many non-deductible
traditional IRA contributions as he is eligible for until he is no
longer eligible to make traditional IRA contribution.
Categories: Pension Alerts, Traditional IRAs