More Wealthier Individuals Should Be Making Non-deductible
IRA Contributions - They Just Need Some Help and You Can Provide It.
Wealthier individuals should be rushing to their IRA
custodian/trustee to make a non-deductible IRA contribution. This is
certainly true if they are a 401(k) participant.
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 2016 Roth
IRA contribution if the couple’s MAGI 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 was $10,000
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?”
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
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
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 nontaxable 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 ($2,809.18) . Jane made a non-deductible 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 non-deductible 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 $8,540 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
$8,540 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 would rollover a portion of the $15,040,
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.
Jane wants to make as many non-deductible IRA contributions
(currently $6,500 but his amount which change as it is indexed for
inflation) as she can between ages 54-70½ 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 non-deductible 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 and convert it? Contributing $6500 for 13 or 14 years would result
in an additional $84,500 or $91,000 in a Roth IRA. Those individuals
attaining age 70 between July and December 31st are eligible to make
a contribution for their "70" year whereas those who attain
age 70 and 70½ are ineligible.
Be aware that under existing laws Roth IRA funds are
ineligible to be rolled over into a 401(k) plan. This is true even for
401(k) plans having Designated Roth features.
Mark too should want to make as many non-deductible
traditional IRA contributions as he is eligible for until his 70½
In summary, a bank president and his/her spouse want
to make as many non-deductible traditional IRA contributions as possible
prior to his/her 70½ year. With some pre-planning, it will be
possible to convert these to be Roth IRA conversion contributions.