Despite Hassle, IRA Can Still Make Sense
It’s individual retirement account season again. But if you are among a growing number of higher-income investors whose IRA contributions are no longer tax deductible, you must proceed carefully--or risk paper-work headaches, penalties and unnecessary taxes in the future.
As you probably know by now, tax reform imposed stricter rules on who can claim deductions for IRA contributions. Under the new rules, if you or your spouse are eligible to participate in a company retirement plan and earn an adjusted gross income exceeding $35,000 for singles or $50,000 for couples filing jointly, you can no longer deduct your contributions.
If your adjusted gross income is between $25,000 and $35,000 for singles or between $40,000 and $50,000 for couples, your maximum deduction will be reduced by 20 cents for each dollar your income exceeds the bottom of those ranges (although you can still make a minimum $200 deductible contribution if you are within those ranges).
But making an annual contribution up to the maximum $2,000 per individual on a non-deductible basis can still make sense. That’s because even though you can’t write off your contribution, investment earnings inside your IRA can still grow on a tax-deferred basis until withdrawn. Thus, investments in IRAs can build up earnings faster than comparable investments held outside IRAs that are taxable each year.
Accordingly, some 1.2 million households made non-deductible IRA contributions in the 1987 tax year, and more are expected to do so before the April 17 deadline for 1988 contributions, says James Dorsey, editor and publisher of IRA Reporter, a Cleveland newsletter. (The normal IRA deadline of April 15 falls on a Saturday, so you get two extra days to make your 1988 contribution.)
But before making a non-deductible contribution, you must consider the extra record keeping and tax filing burden it will impose. That’s because when you withdraw IRA funds, you won’t have to pay taxes on whatever portion was not deductible, since that was already taxed once.
Instead, you will be taxed on a prorated basis depending on the proportion of your accounts that was non-deductible. So, for example, if 20% of all your IRA monies are from non-deductible contributions, then 20% of each dollar you withdraw will not be taxable.
But your records and filings must show how much you have in non-deductible funds. Without those records, the Internal Revenue Service may assume that all your IRA monies are taxable, IRS spokeswoman Shirley Nakagawa says.
That paper-work burden, along with the 10% penalty imposed on premature IRA withdrawals made before you reach the age of 59 1/2, argues against making non-deductible contributions, contends Julian Block, a tax expert in Larchmont, N.Y., with Prentice Hall Information Services.
“Most people simply aren’t going to be sufficiently diligent to keep these kinds of records,” Block says. “That could come back to haunt them later” by additional taxes.
Fortunately, more financial institutions are offering services to help keep track of your non-deductible IRAs or file the required tax forms. By using these services, or following a few safeguards and pointers on your own, you can minimize potential hassles and taxes.
Here are some tips to help you comply with rules for non-deductible IRAs:
-File and keep copies of Form 8606 as long as you have IRAs. You are required to file this complicated new IRS form each year if you have non-deductible contributions and you put IRA money in or took it out in that year. The form will serve as evidence to show what proportion of your accounts derive from non-deductible contributions.
Failure to file Form 8606 will cost you a $50 penalty, thanks to a new tax bill enacted by Congress last year.
And failing to file or losing copies “could mean big bucks” in unnecessary taxes when you withdraw IRA money, newsletter editor Dorsey says. He notes that if you and your spouse each put in the maximum $2,000 non-deductible contribution each year for 20 years, you would have $80,000 of IRA money that has already been taxed.
So failing to keep copies of some or all of your 8606 forms--or having no other records to prove non-deductible contributions--could end up costing you as much as $26,400, which is the tax on $80,000 if you are in the top 33% bracket.
What if you ask your tax preparer to keep your filings? That’s OK, but he or she could go out of business or lose your records, tax expert Block says. And financial institutions holding your IRAs may not keep good records either.
“So really the burden is on the taxpayer,” Block says. “I’d be uncertain whether diary entries alone will suffice.”
Accordingly, some experts suggest, keep your Form 8606 copies in a secure place such as a safe deposit box.
- Keep copies of information returns as well. Financial institutions holding your IRAs are required to file several information returns with the IRS. They include Form 1099-R to record your total withdrawals, Form W-2P to record your partial withdrawals and Form 5498 to show your yearly contributions and the value of your account for each year when you withdraw funds.
Hold on to these as long as you have IRA monies. You also should keep copies of your Form 1040s for years when you withdraw IRA funds.
- Consider combining your IRAs into one account at one institution that will do record keeping for you.
Several larger savings institutions and brokerages, realizing that a growing number of investors are making non-deductible contributions, are offering to help with the paper-work burden.
Wells Fargo Bank, for example, will provide you with account statements detailing your IRA, including exactly how much money derives from non-deductible contributions. The statements also help tell you what figures to record in Form 8086, a complicated document that could take you hours to understand and complete. The cost of this service is built into the annual maintenance fee, says Mabel Dean, Wells Fargo’s senior product manager of retirement programs.
Merrill Lynch, like other big brokerage firms, also will provide such statements. It also will go one step further. For a $25 fee, it will fill out Form 8086 for you, provided you have all your IRAs at Merrill Lynch.
What about keeping a separate IRA account for your non-deductible IRA monies? That could simplify record keeping, newsletter editor Dorsey suggests.
But separate accounts could subject you to higher service charges and sales commissions, Dorsey warns. You also may not meet the higher minimum account balances required to open certain accounts at brokerages and insurance companies. And you may miss out on the higher interest rates some savings institutions pay for larger deposits.
Another drawback of separate accounts: When making withdrawals, you will be taxed on a prorated basis depending on the percentage of money in all your IRAs attributed to non-deductible contributions. So there is no tax advantage in withdrawing from accounts with only non-deductible funds.
For more information about non-deductible IRAs, call the IRS at (800) 424-FORM and ask for Publication 590, “Individual Retirement Arrangements.”
Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.
