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How You Own Assets Impacts Taxes: Non-Deductible

In some cases there are after-tax contributions to "traditional” accounts, namely non-deductible IRAs and contributions made to the Thrift Savings Plan when in a COMBAT ZONE.

The government says that if you make too much money you cannot deduct your TRADITIONAL IRA contribution. It also says that if you make too much money you cannot fund a ROTH IRA. In this case you may want to fund a "non deductible” IRA.

  • Although you can’t deduct your dollars contributed, you benefit from tax-deferred growth. That is to say you aren’t nickeled and dimed with Interest, Dividend and Capital Gains distributions each year. 

  • Upon withdrawal, a percent of the dollars are considered "return of basis” (a.k.a. the dollars you contributed) and since you already paid taxes on it, it is not taxed. A percent is considered growth and it is taxed at Ordinary Income rates. An IRS formula determines what percent is which.

  • You will incur a 10% penalty for withdrawals of growth prior to age 59½.
Be sure to file a FORM 8606 along with your tax return to track your after-tax contributions, a.k.a. "basis" in your Non-Deductible IRAs.

NOTE:  Tax-deferred growth is important. When you have a few thousand dollars put away, the Capital Gains, Interest and Dividends distributed each year may not be a big deal. But once you have a serious portfolio of several hundred thousand dollars or more… they could knock you into the stratosphere in terms of taxes.

Since there are currently no income limits on who can convert an IRA or other accounts to a ROTH, you can immediately convert that Non-Deductible IRA to a ROTH. Since you contributed after-tax dollars, the only taxes owed will be on any growth in the account. 

CAUTION!  Consider the sum of all TRADITIONAL IRAs,SEP IRAs, SIMPLE IRAs, IRA Rollover Accounts and Non-Deductible IRAs before converting to a ROTH.  The IRS will take into account the total of these accounts in determining how much is taxable pro rata upon converting to a ROTH.  You do not need to worry about this if you have no other IRA balances.  If you are considering this strategy, delay rolling over 401(k), TSP or employer-sponsored plan balances to an IRA until the following tax year.  Alternatively, consider "rolling in" TRADITIONAL IRA assets to your employer-sponsored plan prior to converting. 

<NEXT:  A Word about other "Tax-Advantaged" Vehicles>

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