After Tax Contributions to a Traditional IRA

After Tax Contributions to a Traditional IRA

Non-Deductible IRA vs Brokerage Account


After tax contributions to a traditional IRA are a common problem. This results in basis in your IRA. That is, you have money that you have already paid taxes on in a usually pre-tax account!

You get basis in your IRA if you contribute to an IRA even though you make too much to take a tax deduction. Every year you get to file a form 8606 to track the basis in your IRA. And remember, due to the aggregation rule, all of your IRAs (not Roth IRAs) are considered a single account for IRS purposes.

After tax contributions are in the news right now, as there is a proposal to end Roth conversion of after tax contributions to a traditional IRA (the Backdoor Roth) AND to after tax contributions to a 401k (the so-called Mega Backdoor 401k to Roth IRA Rollover).

If this proposal goes through, this might be your last opportunity to liberate to a Roth these after tax contributions to a traditional IRA.

Let’s dig in deep regarding basis in an IRA and see what you can do about it, and talk about the future of after tax contributions to your IRA.


What is an After Tax Contribution to an IRA?

Not infrequently, high income folks continue to contribute to an IRA even though they earn too much to take a tax deduction. Since this money cannot be deducted for tax purposes, it is considered after-tax basis in your IRA.

Anyone can contribute $6000 a year ($7000 if older than 50) if you have earned income (or a spouse that does—a spousal IRA contribution).

What is an after tax contribution to an IRA? It is simply a contribution you make that you are unable to deduct on your taxes because you phase out of the MAGI income limits. If you are unable to deduct the money (and have it be “pre-tax”), then it is basis or after tax basis in your IRA.

Not infrequently, CPAs don’t know what to do about this situation. They allow clients to continue to make non-deductible contributions and they may file form 8606 every year to track the after tax basis. And sometimes form 8606 gets lost which means you might wind up paying taxes on the after tax money! Double taxation! Also, many CPAs are not familiar with the Backdoor Roth so they haven’t been talking to their clients about converting those after tax contributions to the traditional IRA into Roth—which is a tax-free event.

After tax contributions to a traditional IRA are likely going to be around for a while even if the Backdoor Roth goes away. Many folks contribute to the IRA every year regardless of MAGI.

Since there is some urgency to convert after tax basis in the IRA to Roth (as you might not be able to do it next year!), let’s talk about that first and then discuss investing in a non deductible IRA vs a brokerage account.


Pro Rata Rule and Getting Basis out of an After Tax Traditional IRA

Unfortunately, all growth of after-tax money in your traditional IRA is taxable! If you could convert it to Roth, future growth is tax free!

As I mentioned above, due to the aggregation rule, the IRS considers all of your IRAs as a single account and values them once, on December 31st.

What is the pro-rate rule? It states that if you have after tax and pre-tax contributions in your IRA, any withdrawal or Roth conversion comes out in proportion to the after- and pre-tax amounts.

This means if you have a small amount of after tax contributions in your traditional IRA, you cannot do a Roth conversion of just the after tax amounts, you must convert it pro-rata.

Ed Slott describes this as the cream-in-the-coffee problem. The after tax “cream” is equally distributed through the pre-tax coffee.

How can you separate the after tax money in your IRA and get it into your Roth?


Do you have after tax contributions (also called basis) in your traditional IRA?

First thing to check is your most recent tax return. Do you see form 8606? This is a form that you (should) file every year with the IRS to show how much basis you have in your IRA.

It is common for people to forget to file form 8606, or drop it after a few years. Remember that form 8606 is not “proof” to the IRS that you have basis in your IRA, it is merely a work sheet to keep track of it.

You can go back and reconstruct your basis in your IRA if you have lost form 8606 or you are missing a few years. It is worth your time to do so now. Keep records of the basis you report on 8606 as, again, this form is just a work sheet, not evidence in case of IRS audit.


What happens if you forget to record your basis in a traditional IRA?

When you take a distribution from an IRA, it is fully taxable at ordinary tax rates unless you use form 8606 to show you are taking a pro-rata tax deduction due to basis. The same issue affects a Roth conversion—they are fully taxable unless you have form 8606 to demonstrate that part of the contributions are after tax.

If you don’t report that a distribution contains after-tax (basis) via the 8606 on your taxes, you will owe taxes on money that has already been taxed.

Remember, in the eyes of the IRS, you only have one IRA.

You may have a SEP and a SIMPLE and a rollover and three different other traditional IRAs. But the IRS doesn’t care about separate accounts. It is all one. This is called the IRS Aggregation Rule; you only have one IRA in the eyes of the IRS. If you have basis in one IRA (or even if you keep one IRA separate just for your after-tax contributions) and try to convert it to a Roth, you are going to bump against the pro-rata rule.

The Pro-Rata Rule

The pro-rata rule is used to determine how much of a distribution is taxable when your IRA has both pre-tax and after-tax (basis) dollars. You take the ratio, and then determine the amount that is taxable.

As a simple example, say you have 6k a basis and 6k of pre-tax in your IRA (as you might if you had a non-deductible IRA one year and deducted your IRA before). If you distribute the money (or do a Roth conversion), you will pay taxes on 6/12 or 50% of the money (as long as you use 8606 to show your basis).

If you have a SEP or a rollover IRA with 600k of pre-tax money and 6k of after tax contribution, then only 6/606 or about 1% that escapes taxation.

This is the pro-rata or proportion you have in after tax vs. pre-tax.

The pro-rata rule is what keeps many people from doing a yearly Backdoor Roth IRA. (It does not prevent you from doing the Mega Backdoor 401k to Roth IRA because this is done in a 401k and not an IRA.)


Cream in the Coffee (How to separate after tax contributions in your traditional IRA)

If you have just a bit of basis (cream) in your large IRA (the coffee), it is all mixed together. You can’t take a sip (a distribution or conversion) without getting both!

How can you get the cream out? After all, the basis grows in your IRA but you owe ordinary taxes on the growth. It would be nice to separate the cream from the coffee so you can Roth convert the basis and get tax-free growth. In order to get the cream out, you take advantage of the fact that you can only roll-over pre-tax money into a 401k. By law, 401k plans will only accept roll-ins of pre-tax money.

Say you have a 401k at work, or a solo 401k from 1099 income. Most of the time (read the summary plan document), 401k plans allow roll-ins of pre-tax IRAs (or other retirement plans).

So, if you have 6k of basis and 6k of pre-tax money in your IRA, you could roll in 6k to your 401k and then do a Roth conversion tax-free with the remaining after tax contribution. Or if you have 600k of pre-tax money from a separate rollover, you could roll that money back into a current 401k to get that messy 6k of basis in a Roth. This also gets form 8606 out of your life for good.

As long as you have a zero pre-tax IRA balance on December 31st (the only time the IRS applies the aggregation rule is on December 31st every year), you have done it! You separated the after tax basis in your IRA.


Get After Tax Contributions out of your IRA!

As I mentioned above, there are proposals before congress to end Roth conversions of after tax contributions. This means if you have cream in your coffee (after tax contributions in your traditional IRA), you must get them out before the end of the year!

If you don’t, you might be stuck with cream in your coffee for the rest of your life.

As a final note, remember you can do a once in a life time HSA roll over (a QHFD) to get rid of a small amount of pre-tax money from your IRA as well. Fun fact.


[update: of course the day I publish this, I get forwarded a bit  by a reader that describes that the prohibition of Roth conversions on after tax contributions has been removed from the proposed legislation. I’m not sure this will stick, after all there is no downside for congress to do this. They already have their taxes and they just get more taxes in the future through this prohibition. If it doesn’t make it this year, I expect it will soon!]


Next, since people will no longer be able to Roth convert after tax contributions to a traditional IRA, let’s discuss investing in a non-deductible IRA vs a brokerage account.


Non Deductible IRA Vs Brokerage Account

Are there advantages to using a non deductible IRA vs a brokerage account?

Should you use a non deductible IRA or a brokerage (after tax) account for investing? Is there a significant advantage to the tax-deferred growth over time which limits tax drag, or is it much to do about nothing?

Let’s look at a small $10k investment in either a regular investment account or a non-deductible IRA and see what happens over time.

What about someone who is 40 years old and earns $200,000 a year. She puts 6% in her 401k, and then invests in a non deductible IRA vs a brokerage account. Everything is invested in a total stock market index fund paying 7% with 2% yearly dividends.


Results of Investing in non deductible vs brokerage account

After Tax Contributions to a Traditional IRA

Above, you can see the results over time of investing in a non deductible IRA vs a brokerage account.

When she is 65, she has 58k of money in her IRA, of which only 10k is basis (the original 10k of after tax contribution she make to her traditional IRA). Look at the total and you can see that the account with the TIRA (traditional IRA) has 14k more due to savings on tax drag over the 25 years. Tax drag is why you would invest in a non deductible IRA vs a brokerage account.

However, once you start taking RMDs at age 72, the money is forced out of a traditional IRA but not a brokerage account. Note at age 90, the TIRA account is still larger due to the continued deferral of taxes in the (originally) small non deductible IRA.


Conclusion for Non Deductible IRA vs Brokerage Account

Small tax differences over 50 years make a big difference in the end. Even a small contribution to a non-deductible IRA provides benefit after a long period of time.

The tax-deferral decreases tax drag. Even when using a very tax efficient total stock market index fund (with 2% yearly dividends exposed to your capital gain rate), there is a difference. If we used tax-inefficient funds in our asset location (such as REITS, or bonds, or actively managed funds, etc), the difference would be even more pronounced.

In addition, taking Required Minimum Distributions can spread out the pain (tax payments) over time. This is why you should almost never take a lump sum out of your tax-deferred accounts.

Take advantage of every dime of tax-protected space you can. Who knows what the future will be like with tax reform, but even a year or two’s investment into tax-deferred space makes a big difference over decades.


After Tax Contributions to a Traditional IRA

After tax contributions to a traditional IRA used to be a great idea because you could count on converting them to Roth via a Backdoor Roth. Considerations included the pro-rata rule, the aggregation rule, and form 8606.

However, since it looks like after tax Roth conversions are going away, is investing in a non deductible IRA vs a brokerage account better? I like to keep it simple and not track basis in my after tax and pre-tax IRA. If you have a large amount of pre-tax money already (401k, 403b, 457b, etc), then consider skipping after tax contributions to your IRA. Avoiding tax drag is important, but so is keeping things simple.


Finally, remember to check out my end of the year tax planning guide for physicians.

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  1. Just trying to clarify….in your example above of the woman who invested in her TIRA instead of her taxable brokerage, she had $14K more at age 65 and $64K more at age 90. But aren’t those amounts prior to taking withdrawals which would be taxed at ordinary income rates, whereas if she invested in a taxable brokerage account, she’d presumably pay the more favorable capital gains rate? Between that and the lack of RMDs in the taxable account, I wonder if that would make up for “benefit” of investing in the TIRA. Am I looking at this wrong?

    • You are looking at it exactly right. The loss of tax drag over the decades, however, did make this work and the 64k is after RMDs have been accounted for. This was originally part of a larger blog where I showed that as well. The more tax inefficient funds you have in your TIRA, the better the results. But if you want flexibility and simplicity, stick with the brokerage account.

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