As we approach tax time, you will likely be prompted by your tax software or preparer to consider an IRA contribution. If you’re ineligible to deduct your IRA contribution or you’re over the income limit for Roth IRA contributions, you might see a non-deductible IRA contribution suggested. That seems like a good idea. You’re adding more money to your retirement savings, right? However, before you make that non-deductible contribution, please pause and consider whether it’s actually beneficial for you.
Earnings on non-deductible IRA contributions
Earnings on non-deductible IRA contributions are taxed as regular income when withdrawn. When you make a non-deductible IRA contribution, you could have put that same money into a taxable investment account. You can use these taxable investment accounts to save for retirement, so it’s helpful to compare the tax treatment of the two account types.
Earnings in taxable investment accounts benefit from preferential tax treatment. Long-term capital gains and qualified dividends receive a lower tax rate than regular income. Current long-term capital gain and qualified dividend rates are between 0% – 20% while regular income tax rates range from 10% – 37%.
With non-deductible IRA earnings, you benefit from deferred taxation on the growth as these earnings are taxed when you take a distribution.
With a taxable investment account, you pay taxes on your dividends each year even if you reinvest those dividends. You are able to defer taxes on your capital gains until you sell the investments.
In comparing the relative value of tax-deferred growth in the IRA against the preferential tax rates of the taxable investment account, many factors can affect the outcome. In general, though, the preferential tax rates of the taxable investment account outweigh the benefits of tax-deferred growth of the IRA.
Non-deductible IRA contributions require reporting
Many savers falsely believe that their IRA custodian (Vanguard, Fidelity, Schwab, etc.) is tracking which of their IRA contributions are non-deductible. That’s just not the case. The custodians know that you made a contribution for a particular tax year, but they have no way of knowing whether you were able to deduct that contribution.
Tracking lifetime non-deductible IRA contributions is between you and the IRS. To let the IRS know of your contribution, you need to file form 8606 to report it. And then, you need to retain those records as long as you have any balances in IRAs, so possibly for the rest of your life. The best way to retain the records is to file form 8606 every year even if you didn’t make an additional non-deductible IRA contribution. That way, you keep a running total of your non-deductible contributions even if you change tax software or preparers.
The cost of reporting errors
The most common error we see with form 8606 is a failure to file it at all. Or, when someone changes tax software or preparers, the previous records are not carried forward. This error is costly.
When the 8606 is properly filed, the taxable amount of each IRA distribution is calculated as a pro-rata amount of the percentage of pre-tax assets in all your IRAs. Let’s say you take a $5,000 distribution. The total balance in all IRAs at the end of that year is $95,000. Your total amount of after-tax contributions is $10,000. With a properly filed 8606, you will only pay tax on $4,500 of that distribution because 10% of it was from your after-tax contributions.
However, let’s say you never filed the 8606 or didn’t keep up with it along the way. Without correcting the issue, you will now pay tax on the full $5,000. What a waste! You are paying taxes on that $500 twice — once when you made the non-deductible IRA contribution and again when you took the money out.
To correct the issue, you can still reconstruct those records. If you believe you’ve made non-deductible IRA contributions in the past but don’t have a current form 8606 with this year’s tax return, we’d encourage you to research this now. Go back through previous tax returns to check for IRA deductions or form 8606. Work with a tax preparer to bring your filings / records up to date so that you don’t pay tax on the same dollars twice.
So, are non-deductible IRA contributions good or bad?
Non-deductible IRA contributions are generally not optimal. When we consider the loss of preferential tax rates on the earnings available through the taxable investment account and the reporting responsibilities, we typically don’t recommend them. However, there is an exception to this, and it’s a big/important one. Using the non-deductible IRA contribution to execute the backdoor Roth strategy can be a highly impactful long-term planning tool. Here all the details on the backdoor Roth strategy.
If you’re trying to make a decision about IRA contributions for 2025 or 2026, please reach out and we’re happy to chat.