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I've contributed $5500 to a Traditional IRA, planning for that to be tax deductible. My employer didn't have a 401k plan earlier in the year, but will have one implemented before the end of this year (2014), and I'm planning to probably contribute as much as I can to it.

Depending on my income (based on the table here), this would make my $5500 IRA contribution not tax deductible.

Wikipedia says that Traditional IRA "withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted)".

My question is: Since my non-deductible IRA contributions are in the same account as deductible contributions, how would it be determined in retirement how much of which withdrawals are taxed? This seems a bit complicated, as the account is appreciating in value, and additional contributions will be made in the future.

Also: Should I be considering other options (like converting the non-deductible contribution to a Roth IRA)?

  • Oh, I think I get it: It's really just $5500 (the non-deductible contribution) that I avoid taxes on during retirement. Any gains would be taxed at my tax rate for ordinary income during retirement. That's a bad deal! I wish I'd put it in a Roth IRA instead. – DavidC Nov 7 '14 at 1:03
  • You can convert to Roth and only have to pay income taxes on the gains, since your contribution was non-deductible. – Craig W Nov 7 '14 at 1:33
  • How does one figure out which gains correspond to the part converting to Roth? (I've also rolled over an old 401k into the same account recently...) – DavidC Nov 7 '14 at 3:07
  • Scratch that, re-characterization is a better idea, as discussed in Dilip's answer. – Craig W Nov 7 '14 at 3:20
  • Note that the presence of the 401K option is what causes the issue, not your decision to contribute. Your employer must have had a specific reason for doing this by the end of the year, because it is always painful when a December event invalidates a whole year of tax planning. – mhoran_psprep Nov 7 '14 at 10:59
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If you make a nondeductible contribution to a Traditional IRA, you need to tell the IRS that you have done so by filing Form 8606 along with your income tax return (Form 1040). That gives you a basis in your Traditional IRA and that money will not be taxed when it comes out at retirement time. If you neglect to file Form 8606, then the IRS's position is that the contribution is pre-tax and so you have to pay tax on it again.

You can ask your IRA custodian to re-characterize your Traditional IRA contribution as a Roth IRA contribution as long as you do it before the due date of your tax return. But do check the limitations on making Roth IRA contributions. Many people who cannot make a deductible contribution to a Traditional IRA because of high income are also ineligible to make a contribution to a Roth IRA on the same grounds. (But they can make a nondeductible contribution to a Traditional IRA and if they do so, they should report it on Form 8606).

  • Thanks! Seems like re-characterizing is my best option, but I don't know if Wealthfront will do that for me. I'll get in touch with them. – DavidC Nov 7 '14 at 5:27
  • @DavidC: Are you sure you meet the income limits for contributing to a Roth IRA? – user102008 Nov 7 '14 at 20:21
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The determination is based proportionally. If at the retirement time you have 110K in your IRA, of which you have 5.5K basis (that you didn't deduct this year) - you have 5% basis in your IRA, and 5% of your withdrawals will be tax free. I.e.: you take out $100 - you pay tax on $95.

You'll have to keep track of all that on the form 8606, which you also should file in the year when you have non-deductible contributions. This form is your only documentation for the IRA basis, and you don't file it - you cannot claim the basis.

If you don't have any other IRA than these $5500, you can convert it to Roth to keep the gains tax-free as well. If you do have other IRA amounts then the conversion will also be taxed proportionally in the similar fashion.

  • The OP claims in a comment that he has recently rolled over a 401k from an ex-employer into his Traditional IRA account, and so converting to Roth will certainly need proportional treatment as in your last paragraph. – Dilip Sarwate Nov 7 '14 at 3:53
  • Then converting will probably not be a good idea. Generally keeping a non-deductible IRA balance is a bad idea. – littleadv Nov 7 '14 at 5:23
  • "Then converting will probably not be a good idea" <== Seems right! Sounds like my best option is recharactarizing as in Dilip's answer. I'm unsure whether my IRA custodian (Wealthfront) will do that, though. – DavidC Nov 7 '14 at 5:26
  • @DavidC no reason for them not to. It is a common operation - many people contribute to IRA without knowing whether they'll be able to deduct it. However, keep in mind that there are income limits for Roth IRA. – littleadv Nov 7 '14 at 5:27
  • Yep, thanks for the income limits reminder. I'll definitely double-check those. – DavidC Nov 7 '14 at 5:28

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