Executive Summary
The non-deductible IRA has long been a financial planning tool, albeit one that has become far less popular in recent years, given the tax preferences for both qualified dividends and long-term capital gains.
However, with the new 3.8% Medicare surtax on net investment income that took effect in 2013, a new incentive has emerged: even with ordinary income treatment, the non-deductible IRA provides a way to permanently avoid the surtax, which would otherwise apply to interest, dividends, and capital gains, as well as income from other tax-deferred vehicles like deferred annuities.
The strategy is especially appealing to those who are in the peak income years of their career, where a Roth conversion is unappealing due to the high current tax bracket (and other IRAs that will be aggregated), tax deferral is valuable, and a permanent avoidance of the 3.8% Medicare tax provides yet another added value... especially if the account will hold fixed income investments that were going to be taxed at ordinary income rates anyway.
Fortunately, the strategy is available regardless of how high income rises (and in fact, is best at high income levels), and while the value of the strategy is limited by the IRA contribution limit of $5,500 in 2013 2015, several years of compounded efforts can still potentially produce a significant tax savings in the future!
Rules On After-Tax Non-Deductible IRA Contributions
Although often misunderstood, the tax code actually permits anyone with earned income from wages or self employment (and under the age of 70 1/2) to contribute to an IRA, regardless of how high their income may be. There is no high income phaseout that limits the contribution to a traditional IRA, the way there is for a Roth IRA.
However, if the individual is an active participant covered by an employer retirement plan, then the deductibility of the IRA contribution may be limited at higher income levels (with a separate set of income limits in situations where the individual is not covered by an employer retirement plan, but his/her spouse is). As a result of these rules, many high income individuals who are covered by employer retirement plans can still make an IRA contribution (as there is no maximum income limit), but will be required to treat it as a non-deductible IRA contribution.
In recent years, non-deductible IRA contributions have become less popular, though. In part, this was due to the tax preferences afforded to both long-term capital gains and qualified dividends, which allow the growth on equities to be taxed at more favorable rates in taxable accounts than in a non-deductible IRA (which ultimately taxes growth as ordinary income when withdrawn). Although it was still possible to eventually gain enough from tax-deferred growth to make up this tax rate differential, the required holding period was so long that planners and clients rarely chose to go this route. To the extent non-deductible IRAs have been used at all, it has more typically been as an indirect path to getting money into a Roth IRA, rather than to actually enjoy the tax benefits of a non-deductible IRA.
The New 3.8% Medicare Tax On Net Investment Income
As a part of President Obama's Patient Protection and Affordable Care Act, 2013 marked the start of the new 3.8% Medicare tax on unearned income (i.e., "net investment income" as defined by the tax code and regulations). Applied to high-income earners (those with more than $200,000 of AGI as individuals, or $250,000 for married couples), the tax covers a broad swath of investment income, from dividends and interest, to most forms of passive income, to capital gains.
However, an exception applies under IRC Section 1411(c)(5) to any distributions from qualified retirement accounts, including IRAs, Roth IRAs, pensions, 401(k) and 403(b) plans, profit-sharing plans, and more. While distributions from such accounts are still income - and in the extreme, can push a client across the aforementioned AGI threshold - the distributions are not counted as "net investment income" for the purposes of the new Medicare tax.
As a result of this exception, growth that occurs inside of retirement accounts is not just tax-deferred for ordinary income tax purposes... it also permanently escapes the scope of the new 3.8% Medicare tax!
Non-Deductible IRA Contributions To Escape The 3.8% Medicare Tax
As a result of the new 3.8% Medicare tax in 2013, there is a new opportunity and reason for making non-deductible IRA contributions - as a proactive strategy to avoid the new Medicare tax for high-income clients.
Notably, the confluence of factors aligns well; high income individuals are simultaneously exposed to the new 3.8% Medicare tax, unable to make Roth IRA contributions, and can still make non-deductible IRA contributions even after contributing to an employer retirement plan. As a result, the clients most eligible to make non-deductible IRA contributions are arguably the ones who need it the most!
The strategy is likely to be most appealing for clients who have relatively limited IRA assets already, for the simple reason that the (non-deductible) IRA can then be used to shelter any fixed income investments that the client has. After all, as long as bonds and other ordinary income investments are held inside the non-deductible IRA, the reality is that the growth is going to be taxed at ordinary income rates no matter what; the only question is whether the 3.8% Medicare tax will be tacked on top. Thus, to the extent that bond and other ordinary income investment holdings exceed the available IRA assets to shelter, non-deductible IRA contributions may be more appealing.
In addition, it's notable that this issue and opportunity applies primarily to people who are exposed to the 3.8% Medicare tax and are still working (while retirees may be exposed as well, they have no earned income, making IRA contributions a moot point). For many clients, this enhances the opportunity, for the simple reason that their ordinary income tax rate will also decline beyond retirement (as even large asset-based portfolios often don't result in as high of a tax bracket and marginal tax rate as peak income working years). As a result, using a non-deductible IRA can not only permanently avoid the 3.8% Medicare tax, but also allows taxes to be deferred until the client's marginal tax rate is lower, effectively producing additional wealth enhancement through a form of tax rate arbitrage. And this strategy may actually be more appealing than simply contributing to a non-deductible IRA and immediately converting it, both because that can be viewed as an abuse of the Roth IRA contribution limits, and because it's not a good idea to do Roth conversions when tax rates are higher now and will be lower later (due to retirement and the elimination of employment income). (Michael's Note: And in the time since this article was first written, President Obama has now proposed limiting the conversion of after-tax dollars in an IRA, specifically to prevent such Roth conversion strategies!)
Given how net investment income is calculated for the Medicare tax, it's also important to bear in mind that the strategy does not work with non-qualified annuities; while the annuity enjoys tax-deferred compounding on after-tax contributions, the exception for the 3.8% Medicare tax only applies to IRAs. IRC Section 1411(c)(1)(A)(i) explicitly states that the tax does apply to [non-qualified] annuities (and in the recent 3.8% Medicare tax Treasury regulation guidance, was confirmed to apply both to annuitized payments from annuity contracts, as well as withdrawals from deferred annuities).
Ultimately, the value of this new strategy is still somewhat limited - given the IRA contribution limit in 2013 will only be $5,500, which may not be very material for someone with enough income to be exposed to the 3.8% Medicare tax. Nonetheless, it still represents a planning opportunity, and one that can compound to material numbers by engaging it systematically over time.
For clients who already have large traditional IRAs, wouldn’t the ratio formula for withdrawals force more of the ND IRA to be taxable in retirement? And if they will be withdrawing (or getting pension) in retirement to replace income, they could still be in a high tax bracket. So they could be paying the surtax in retirement when they might find it easier to pay while working and not have to worry on possible further tax increases to absorb in retirement. Further, in a taxable account, withdrawals are taxed at cap gains rates, lower than if a higher bracket by taking IRA withdrawals. Just some thoughts…