Now Every Wage Earner Can Contribute to Some Form of IRA–Here's How!

By Allen Ostrofe, MBA, CFP® | Originally Published in The Union | Download the PDF 

Eric and Petra, a married couple, both 36 years old and employed, called from Dallas, Texas.  They had just finished their 2018 taxes and calculated with their Certified Financial Planner® that contributing to their employer’s new 401(k) plan plus their past traditional IRA contributions may not be sufficient to meet their retirement goals. Their salary levels prevented making ROTH contributions, and the availability of their employer-sponsored 401(k) plan eliminated them from making traditional IRA contributions. Does the absence of a traditional or ROTH IRA mean no future IRA contributions? Let’s not give up so fast!

Eric and Petra’s Certified Financial Planner® and their tax advisor explained that there is an additional type of IRA available to help them pursue their retirement goals. It is the Non-Deductible IRA, whose contributions can still help Eric and Petra save for their retirement.  While Non-Deductible IRA contributions won’t reduce their taxes in the year they make them, the earnings grow tax-deferred. For younger people, the benefit of long-term tax deferral until retirement (possibly 30 years of deferral for this couple) could actually outweigh the value of the traditional one-year tax write-off. Future withdrawals will be at least partially tax-free.  Following the rules are as simple as 1, 2, 3!

First, you can use Form 8606. The IRS requires the Non-Deductible IRA contributions be reported on this simple, one-page form for the year of the contribution. This makes it easy to track which portion of Eric and Petra’s combined traditional and non-deductible IRAs are taxable and not taxable.  It is a big help in tracking how much their tax basis is year after year.

Second, Non-Deductible IRA contributions can be kept in separate accounts, or co-mingled with traditional IRA contributions. Either way, any withdrawals from the account(s) take into account both the taxable and non-taxable portions of the IRA on a pro-rata basis. Simply put, the pro-rata rule applies across all IRAs owned by Eric and Petra. In this case, Eric and Petra had previously made maximum contributions to their traditional IRAs from age 26 to 35, before they had a 401(k), and had contributed a total of $106,000. They now plan to maximize their Non-Deductible IRAs (utilizing Form 8606) from age 36 to 66, which under current law would be total contributions of $406,000, for a combined total of $512,000 (contributions will most likely be higher due to government cost-of-living index increases).

Third, as with traditional IRAs or ROTH IRAs, Eric and Petra may contribute up to $6,000 each (assuming their combined salaries match or exceed that amount) up until April 15, 2020, for the year 2019. Once they reach the age of 50, they may increase their contributions to up to $7,000 each.

Together with their Certified Financial Planner®, and with the encouragement of their tax preparer, Eric and Petra decided to add Non-Deductible IRA contributions to their existing 401(k) contributions starting in 2019. What changed their minds? The annual savings resulting from adding the Non-Deductible IRAs, compounded at 6% per year, could add an additional $1,140,000 to their retirement plan. This helps them reach what they thought was an impossible financial goal, and it gave them a great lesson on the power of compounding.  

Including both types, their total IRA investment from age 26 through 66 will be $512,000.  Assuming an average of 6% per year growth, the $512,000 will have grown to $2,027,939. And, that doesn’t even include their 401(k) plans. Eric and Petra were excited to see how this free tool of compounding could ultimately change their lives!

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

The Roth IRA offers tax deferral on any earnings in the account.  Withdrawals from the account may be tax-free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRA penalty tax.  Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRA penalty tax in addition to current income tax.  This is a hypothetical situation based on real life examples.  Names and circumstances have been changed.  To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing.

Allen Ostrofe, MBA, CFP®, is President Emeritus of Ostrofe Financial Consultants, Inc., with clients in 32 states and is a registered Representative with, and Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Ostrofe Financial Consultants, Inc., a Registered Investment Advisor and separate entity from LPL Financial. For questions or suggestions, visit ostrofefinancial.com. Branch address: 420 Sierra College Drive, Suite 200, Grass Valley.