June 2016

More Wealthier Individuals Should Be Making Nondeductible Traditional IRA Contributions - They Just Need Some Help and You Can Provide It

Wealthier individuals should be rushing to their bank to make a non-deductible IRA contribution. This is certainly true if they are a 401(k) participant.

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 annual contribution.

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?

1. She may not use the recharacterization rules to make her traditional IRA contribution a Roth IRA contribution as their 2015 MAGI is too high
2. There is no IRS guidance allowing the IRA custodian to switch the year for which the IRA contribution was made from 2015 to 2016
3. 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
4. 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 nondeductible contributions.

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 contributions.

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.

Warning – Determine if Your IRA Processor Has Prepared Some of Your Institution’s 5498 Forms Incorrectly

An IRA custodian called CWF with the following situation/question. Jane Doe has her own personal traditional IRA and she has an inherited traditional IRA arising from her mom. The IRA processor prepared just one combined 2015 Form 5498. Is this correct or permissible?

It is incorrect. Two 5498 forms must be prepared. It is understandable why a software engineer would think that it is better and simpler if just one form 5498 record is prepared rather than multiple forms. It is not simpler. The IRS rules do not permit aggregation of the data when there are multiple IRA plan agreements. The IRS has had the rule for a long time that contributions, distributions and fair market value statements are prepared and reported on a per plan agreement basis.

IRA tax data may be aggregated on a per IRA plan agreement basis, but it is not permissible to aggregate data from multiple IRA plan agreements. For example, Jane Doe age 53 has IRA Plan #1 and makes three $2,000 contributions for tax year 2015 on 3/10/15, 9/10/15 and 3/1/16 and she made a rollover contribution from a 401(k) plan to IRA Plan #1 of $12,000 on 6/10/15 and another rollover contribution from her 401(k) plan of $23,000 on 10/10/15. Box 1 will be completed with $6,000 and box 2 will be completed with $35,000.

As the discussion below illustrates, there is tax logic to the rule that there must be a separate IRA reporting form prepared on a per IRA plan agreement basis rather than allowing the reporting entity to aggregate the information and then furnish one form.

For example, Jane Doe has her own traditional IRA and she has has also inherited her mom’s traditional IRA. There must be two also separate 5498 forms prepared for her. For income taxation purposes she does not aggregate her IRA with the inherited IRA from her mother.

Preparation of a combined Form 5498 is a violation of IRS requirements. The IRS has the authority to assess a fine of $50 for each incorrect form and $50 for each missed form. Remember, the fines are doubled in the sense that one form goes to the IRS and one copy to the individual. Most likely the processor in its contract tries to have the IRA custodian be liable for this type of mistake. It’s CWF opinion that if the processor has written its software to not comply, it should be liable for any IRS fines.

What tax harm is being caused by such impermissible aggregation?

A person must do separate tax calculations for distributions from personal IRAs and inherited IRAs. This capability is lost if the data is aggregated.

If two 5498 forms both show a rollover contribution, most likely the IRS will determine that only one of them qualifies to be a rollover contribution because of the once per year rule and the other would be a taxable distribution. This audit capability is lost if there is just one combined Form 5498 prepared. The IRS prepares many statistical studies based on the info set forth on the 5498 forms. Many analytic capabilities are lost if there is not one Form 5498 prepared for each plan agreement.

CWF's Guidance on Transfers and Direct Rollovers

Direct rollovers from 401(k) plans into traditional IRAs average more than $75,000.

The tax rules applying to a transfer contribution are very different from those applying to rollover contribution (direct or indirect).

Procedures must exist to minimize IRA custodian errors. Errors arise because IRA personnel do not understand that the tax rules differ from transfers and direct rollovers. They are not the same and IRA staff sometimes fail to know this.

For example, a check for $65,000 is sent to First State Bank (FSB) fbo Jane Doe's traditional IRA. The personnel of First State Bank process the contribution as a transfer as they forget to ask the question, "what type of plan issued the check?". The problem is, the check was issued because Jane Doe had instructed her former employer's 401(k) plan to directly roll over her 401(k) funds to a traditional IRA. Since the check was processed as a transfer, FSB did not report this contribution on the Form 5498 as a rollover as it is required to do. No doubt the IRS will contact your customer who will contact you and the IRS will be interested in learning why FSB did not report this rollover on the Form 5498.

Solution. Determine that you and your IRA staff know what is needed to be known regarding transfers, direct rollovers and rollovers. We at CWF can assist. Call us at 800.346.3961 or visit our website for information on webinars, IRA Tests, IRA Procedure Manual and IRA Rollover Certification Forms.

If your IRA rollover form has a print or revision date prior to 2015, it is obsolete and should be discarded.