Allen Ostrofe: Now every wage earner can contribute to some form of IRA…here’s how
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 alone plus their past traditional Individual Retirement Account 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 retirement account contributions. Does no traditional or Roth Individual Retirement Account, mean no future account contributions? Let’s not give up so fast.
Eric and Petra’s financial planner and their tax advisor explained there is an additional type of Individual Retirement Account available to help them pursue their retirement goals. It is the Non-Deductible Individual Retirement Account, whose contributions can still help Eric and Petra save for their retirement. While Non-Deductible Individual Retirement Account 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 one, two, three.
1. The Internal Revenue Service requires the Non-Deductible Individual Retirement Account contributions be reported on a simple, one-page Form 8606 for the year of the contribution. This makes it easy to track which portion of Eric and Petra’s combined traditional and non-deductible Individual Retirement Accounts are taxable and tax-free. It is a big help in tracking how much their tax basis is year after year.
2. Non-Deductible Individual Retirement Account contributions can be kept in separate accounts, or co-mingled with traditional retirement account contributions. Either way, any withdrawals from the account(s) take into account both the taxable and non-taxable portions of the Individual Retirement Account on a pro-rata basis. Simply put, the pro-rata rule applies across all retirement accounts owned by Eric and Petra. In this case, they had previously made maximum contributions to their traditional accounts 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 Individual Retirement Accounts (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).
3. Just like traditional Individual Retirement Accounts or Roth Individual Retirement Accounts, Eric and Petra for the year 2019, may contribute up to $6,000 each (assuming their combined salaries match or exceed that amount) up until April 15, 2020. Once they reach the age of 50, they may increase their contributions to up to $7,000 each.
Together with their financial planner, and with the encouragement of their tax preparer, Eric and Petra decided to add Non-Deductible Individual Retirement Account contributions to their existing 401(k) contributions starting in 2019. What changed their mind? This annual savings resultant 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 retirement investment from age 26 through 66 will be $512,000. Assuming an average of 6 percent 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.
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.
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