Why Federal Employees Should Review the Status of Their Traditional IRAs

It’s a good idea for those employees and annuitants who own traditional IRAs to review the status of their traditional IRAs; in particular, whether they own “deductible” traditional IRAs or “nondeductible” traditional  IRAs. This column discusses why reviewing the status of one’s traditional IRAs is important for retirement planning purposes.

It is important to first present a brief history of the Individual Retirement Arrangement, commonly called the IRA. The traditional IRA was created by Congress in 1974, allowing individuals to contribute additionally towards their retirement. Additionally in the sense that in 1974 many Americans, including federal employees, were covered by some type of pension plan.

In addition, contributing to IRAs allowed Americans who are not covered by a company pension plan such as self-employed individuals to save for their retirement. As an incentive for individuals to contribute to an IRA, Congress when it passed legislation creating IRAs allowed for current tax savings. In particular, all contributions to IRAs were deducted from an individual’s gross income, lowering the individual’s Federal and state adjusted gross income (AGI) resulting in lower tax liabilities. For individuals in the high tax brackets in the 1970’s and early 1980’s (perhaps as high as being in a combined bracket of 50 to 70 percent), IRA contributions were therefore an ideal way of reducing federal and state tax liabilities. In addition, any earnings in the traditional IRA were not taxed until withdrawn, perhaps many years in the future when the IRA owner would likely be in a lower federal and state tax bracket. The IRA therefore results in current tax savings and tax-deferred and compounded growth for one’s retirement years.

But the law changed in 1986. Congress passed the Tax Simplification Act of 1986. Among its features, the new law created the nondeductible traditional IRA. In particular, the new law included a provision that if an individual is covered by an employer-sponsored retirement plan, then depending on the amount of the individual’s modified adjusted gross income (MAGI), the individual may be ineligible to contribute to a deductible traditional IRA. The individual can instead contribute to a nondeductible traditional IRA in which the contribution to the IRA does not result in current tax savings to the IRA owner. The tax benefit is that the contributions and the earnings grow from year-to-year with no taxes due until the IRA funds are withdrawn. Only the accrued earnings in the nondeductible traditional IRA will be taxed when withdrawn. This is because the IRA owner contributed to the nondeductible traditional IRA using already-taxed dollars which will certainly not be taxed again when withdrawn.

Nondeductible traditional IRAs started in 1987. Starting in 1987 and every year since,  the IRS puts out a chart as to which individuals are eligible to contribute to deductible traditional IRAs. There are no income restrictions for contributing to a nondeductible traditional IRA. Whether an individual can contribute to a deductible traditional IRA depends on the following factors: (1)The individual must be under age 70 and have earned income; (2) whether the individual is covered by and participates in an employer-sponsored retirement plan; (3) the individual’s marital status and whether the individual’s spouse is covered by and participates in an employer-sponsored retirement plan; and (4) the individual’s or, if married, the individual’s and spouse’s MAGI. The following chart illustrates the limits for the year 2017:

Example. Thomas and Louise file a married filing joint tax return for 2017. They are both 42 years old and employed. Thomas is a Federal employee covered by FERS and contributes to the Thrift Savings Plan but Louise is not covered by a retirement plan. Their MAGI for 2017 is $101,555. Thomas’ salary is $70,000. Thomas contributes $5,500 to his traditional IRA. Because Thomas’ and Louise’s 2017 MAGI is between $99,000 and $119,000 and Thomas is covered by an employer plan, Thomas’ IRA contribution is subject to the deduction “phase-out” (as presented in an IRS Publication 590-A worksheet) as follows:

Thomas can deduct on their 2017 federal income tax return $4,800 of his $5,500 IRA contribution. The remaining $700 represents is a nondeductible traditional IRA contribution and is reported Thomas’ Form 8606 (see below) which is filed as part of Thomas’ and Louise’s 2017 federal tax return.

 Why should federal employees contribute to a nondeductible traditional IRA if there are no immediate tax benefits? One reason is that the growth on the contribution will be tax-sheltered inside the IRA until  withdrawn. A second reason is that employees who do not own traditional deductible IRAs and who cannot contribute to Roth IRAs because their MAGI is too large can take advantage of the “backdoor” Roth conversion strategy. In fact, the “backdoor” Roth IRA conversion strategy is based primarily on an individual contributing to a nondeductible traditional IRA and immediately converting it to a Roth IRA. Since the contribution to the nondeductible traditional IRA was already taxed, there will be no tax due on the Roth IRA conversion. The qualified Roth IRA withdrawals are also completely tax-free, meaning both contributions and earnings are withdrawn tax-free. The individual who performed a “backdoor” conversion ends up with a tax-free retirement account at no tax-cost upfront. The backdoor Roth IRA is discussed in this column.

Even without converting to a Roth IRA, the earnings in the nondeductible traditional IRA contribution will grow over time tax-deferred. When nondeductible traditional funds are withdrawn, the contributions are withdrawn tax-free albeit on a pro-rata basis with any before-taxed funds in the IRA (earnings) in the IRA. The question therefore becomes: How does the IRS know that there really is after-taxed money inside the nondeductible traditional IRA?

Many federal employees and annuitants with traditional IRAs expect their traditional custodians or trustees to report the taxable and tax-free portions of IRA withdrawal. However, the IRA custodian or trustee does not necessarily know whether the IRA owner received  a tax deduction for his or her traditional IRA contribution. Furthermore, even if the custodian or trustee does know, the “pro rata” rule of contributions and earnings applies to all traditional IRAs owned by an individual The result is that when an individual owns multiple traditional IRAs spread across multiple banks, brokerages, credit unions and insurance companies, there is no way a custodian or trustee could determine the tax-free portion of the withdrawal.

That is where IRS Form 8606 (Nondeductible IRAs) is used. Form 8606 serves multiple purposes. First, it is used by individuals to inform the IRS that they have contributed to a nondeductible traditional IRA. It is used to track these nondeductible contributions over time by keeping a running total. In particular, in any year an individual contributes to a nondeductible traditional IRA, the individual must file Form 8606 with his or her federal income tax return.

Second, Form 8606 is used to perform the “pro rata” calculations needed to figure out the tax-exempt portion of the traditional IRA withdrawal. It also tracks the amount of contributions remaining in the IRA after each withdrawal in order to recalculate the tax-free percentage each year.

Third, Form 8606 is used to determine the tax-exempt portion of the traditional IRA conversion to a Roth IRA. The form tracks the percentage of the tax-exempt portion as traditional IRAs are converted to Roth IRAs.

A logical question therefore is: What happens if an individual has been making nondeductible traditional IRA contributions (and many Federal employees have been since 1987) and never bothered to report these contributions on Form 8606? The good news is that the IRS allows individuals to file Form 8606 for any year since 1987 in which an individual made a nondeductible traditional IRA contribution but did not file Form 8606. The individual need not amend his or her tax return for that year. Instead, the individual should go to www.irs.gov and search for Form 8606 for any year from 1987 through 2016 in which he or she contributed to a nondeductible traditional IRA. Form 8606 and the accompanying instructions should be downloaded, completed, signed, dated and mailed to the IRS Service Center shown in the instructions.

The bad news is that there is a $50 penalty for each Form 8606 filed after the normal filing deadline. But by not filing Form 8606 for any particular year in which the form should have been filed, the IRA owner will pay Federal and state income taxes a second time (likely far exceeding $50) on those nondeductible contributions when these contributions are either withdraw or are converted to a Roth IRA.