Preface: “As in all successful ventures, the foundation of a good retirement is planning.” – Earl Nightingale
History of the Retirement Plan, Part II
The following is the second in a series of blog posts on the subject of retirement plans. The first installment, which can be found here:
-
- Briefly reviewed the history of government-defined retirement models in the United States,
- Introduced the tax-deferred model, and
- Explained the difference between Qualified plans and Individual Retirement Accounts (IRAs).
This second installment will discuss:
-
- Limits to deductibility of retirement contributions, and
- Tax treatment of non-deductible contributions.
Future posts in this series will address:
-
- The Roth model.
Non-Deductible Contributions to IRAs
Within a decade after the creation of the Individual Retirement Account (IRA) in 1974, the government began having second thoughts about letting individuals deduct the entirety of their IRA contributions from taxable income. They were especially concerned with higher-income employees who already had generous qualified retirement plans through their jobs. If you or your spouse could already exclude five figures worth of your wages from your taxable income, why should you also be allowed to deduct your IRA contributions?
The Tax Reform Act of 1986 introduced income limits on deductibility for individuals who were covered by Qualified plans at work and for their spouses, even if the spouse is not covered by a qualified plan.
The dollar amount limits set forth in 1986 are increased every year or so for inflation, but the basic three-tiered system introduced in 1986 is still with us. Here are the 2025 income limits for married filers:
| MFJ, neither covered by Qualified plan | MFJ, covered by Qualified plan | MFJ, not covered by Qualified plan but spouse is |
| All of IRA contribution is deductible with no income limit. | All of IRA contribution is deductible if combined AGI is less than $126,000 | All of IRA contribution is deductible if combined AGI is less than $236,000. |
| None of IRA contribution is deductible if combined AGI is more than $146,000. | None of IRA contribution is deductible if combined AGI is more than $246,000. |
And for single filers:
| Single, not covered by Qualified plan | Single, covered by Qualified plan | |
| All of IRA contribution is deductible with no income limit. | All of IRA contribution is deductible if combined AGI is less than $79,000 | |
| None of IRA contribution is deductible if combined AGI is more than $89,000. |
Under this system, not all money in all IRAs is tax-deferred. Individuals who are limited from deducting their contributions in whole or in part must pay tax on those amounts in the current year. Therefore, some of the money in their IRAs going forward is after-tax money.
This is bad because it means you have to pay tax on it this year. However, it is also beneficial, as you will never have to pay any tax on it again. And the earnings from the after-tax portion of the contribution will have the same tax-deferred status as the earnings from the pre-tax portion.
An IRA is Worth More Than Just Its Deduction
People will sometimes say that they don’t want to contribute anything to an IRA that they cannot deduct on their current year tax return. But consider that if you don’t take the deduction on a contribution now, you will not have to pay tax on it when it is withdrawn. You are in effect taking the deduction after you retire instead of taking it now. Of course, if you expect to be in a lower tax bracket in retirement, the deduction now is worth more than it will be then. But if you cannot take the deduction now, you can still get it later. It is not lost forever. And by contributing the maximum today, you still get the maximum amount of earnings growing tax-deferred.
Example: You contribute $1,000 to your IRA. Of this, you are only able to deduct $500. Over the years, your IRA grows in value to $4,000. After reaching retirement age, you withdraw the $4,000. The $500 you could not deduct is withdrawn tax-free, since tax has already been paid on it. The remaining $3,500 is taxed as ordinary income upon withdrawal.
If you are in a lower tax bracket when you retire, you might feel bad that you had to pay tax on $500 of the contribution back in the day when you were in a higher tax bracket. However, the $3,000 of earnings is still all taxed at the lower rate, even though the non-deducted portion of the contribution generated half of it.
Imagine you had not contributed that $500 because you couldn’t deduct it, but had invested it instead in a taxable brokerage account. Then the $1,500 of earnings it generated would be taxed when you earned it, at the rates you were subject to at the time.
Here is a schematic view of the differences:
| IRA – deducted on contribution | IRA – not deducted | Taxable account | |
| Contributions | Taxed on withdrawal
(lower rate) |
Taxed on contribution
(higher rate) |
Taxed on contribution
(higher rate) |
| Earnings | Taxed on withdrawal
(lower rate) |
Taxed on withdrawal (lower rate) | Taxed as earned
(higher rate) |
Unless your time remaining to retirement is very short, the value of your IRA during retirement resulting from this year’s contribution will likely be more than twice the amount of the contribution. So unless you have reason to think you will not be in a lower tax bracket after you retire, the value of contributing to an IRA is likely greater than the value of your current year deduction. So it is likely still worth contributing the maximum each year, even if you can’t deduct all of it.
Tax Treatment of Withdrawals from Mixed-Status IRAs
If you ever make a contribution to your IRA that is not completely deductible, you are supposed to file Form 8606 every year with your tax return to track the after-tax amount in your IRA from year to year. If you do not track the after-tax portion throughout the life of the IRA, you may have to pay tax on the entirety of your withdrawals.
When you attain retirement age and make a withdrawal, you are supposed to prorate the taxable amount of the withdrawal. The calculation is likewise done on Form 8606.
Example: You contribute $1,000 to your IRA. Of this, you are only able to deduct $500. Over the years, your IRA grows in value to $4,000. After reaching retirement age, you withdraw the $4,000. You have dutifully filed Form 8606 each year of your working life so you can prove that exactly $500 has an after-tax status. The $500 you could not deduct is withdrawn tax-free. The remaining $3,500 is taxed as ordinary income upon withdrawal.
But wait! Let’s say you don’t want to withdraw the entire $4,000. Let’s say you only want to withdraw $1,000. You might think: “I will withdraw the $500 that is after-tax and $500 of the pre-tax money. That way, I will only have to pay tax on half of my withdrawal.”
Unfortunately, that is not how the IRS will see things. Any amount you withdraw from a mixed-status IRA needs to be prorated based on the ratio of total after-tax holdings to the total IRA value. Therefore, only 12.5% ($500/$4,000) (which is to say $125) of your $1,000 withdrawal is tax-free. The other $875 is taxable. You then reduce the after-tax amount of your IRA by the $125 you withdrew and carry the result to next year’s Form 8606
The taxable ratio is computed based on the total pre-tax holdings in all your IRA accounts over the total value of all your IRA accounts. This includes all SEP-IRA and SIMPLE-IRA accounts, but not qualified plans. So you cannot manipulate the taxable proportion of your withdrawals by keeping separate IRA accounts and making withdrawals from the one with the desired taxable proportion.
There are, however, several ways to increase the after-tax proportion of an IRA. One of these is the Qualified Charitable Distribution (QCD).
Strategy #1 for Increasing the After-Tax Proportion of an IRA: Introducing the QCD
The QCD is available to owners of IRAs who are at least 70 years old. They must be made to tax-deductible charitable organizations, and the transfer must be made directly from the IRA. You cannot just write a check to your favorite charity and declare it a QCD. A properly made QCD is entirely pre-tax and cannot be used as an itemized deduction. It is excluded income, which is why none of it can have an after-tax status.
A QCD can be used to fulfill a Required Minimum distribution.
Example: You have $4,000 in your IRA and you have attained retirement age. You have dutifully filed Form 8606 each year of your working life so you can prove that exactly $500 has an after-tax status. The company that administers your IRA informs you that in the current year, you must make a required minimum distribution of $500 to avoid penalties.
You direct your IRA administrator to send a QCD of $500 to your favorite charity. This distribution will not be taxable to you. Furthermore, it reduces the pre-tax part of your IRA by $500 without reducing the after-tax part. After this QCD is made, you are left with a balance of $3,500 in your IRA, $500 of which remains after tax, just as before. You have effectively increased the after-tax proportion of your IRA.
Strategy #2 for Increasing the After-Tax Proportion of an IRA: Rollover to a Qualified Plan
Another way to increase the after-tax portion of your IRA is to make a rollover to a qualified plan. A rollover is simply a transfer of funds from one account to another account with a similar tax status. Because a Qualified plan is pre-tax, all rollover amounts to a Qualified plan must also be pre-tax.
A rollover is not a distribution and cannot be used to fulfill a Required Minimum distribution.
Example: You have $4,000 in your IRA and you have attained retirement age. You have dutifully filed Form 8606 each year of your working life so you can prove that exactly $500 has an after-tax status. The company that administers your IRA informs you that in the current year, you must make a required minimum distribution of $500 to avoid penalties.
You decide that first you will roll over some of the IRA into a Qualified plan you have from a job. The rollover to the Qualified plan can only be from the pre-tax part of the IRA, so you will not be able to roll over more than $3,500. Any amount you do roll over will increase to proportion of the IRA that is after-tax.
If you roll over the entire $3,500, only the $500 of after-tax money will remain in the IRA. This can then be withdrawn to fulfill the RMD, and it is now 100% tax-free. The $3,500 that you rolled over retains its pre-tax status within the Qualified plan, so the rollover is itself a tax-free event.
If you are aware of any alternative methods to increase the after-tax portion of an IRA beyond a QCD or a rollover to a qualified plan, please contact me at bgelbart@saudercpa.com and let me know.