For some clients, an after-tax individual retirement account may be a last resort.
Say that a client named Jane is covered by a retirement plan at work, with modified adjusted gross income of $194,000 or more on a joint tax return.
Neither she nor her husband can deduct 2016 contributions to a traditional IRA. Moreover, neither spouse can make after-tax contributions to a Roth IRA, for future tax-free withdrawals.
What is left? Advisers might point out that workers and their spouses under 70 1/2 generally can make full non-deductible contributions to a traditional IRA, regardless of income.
"We've occasionally used non-deductible IRAs with selected clients," says Jim King, a CFP and the president and founder of J.P. King Advisors, a financial planning and investment advisory firm in Walnut Creek, Calif.
Inside the IRA, earnings are untaxed until money is withdrawn.
An after-tax IRA also has drawbacks, according to King.
"The dollar amount is relatively small," he says, with a maximum contribution of $6,500 this year, for clients 50 or older, "and tax-deferred growth on after-tax savings is not unique to non-deductible IRAs."
Annuities and certain life insurance policies also offer potential tax-free buildup, King says.
Using annuities or life insurance will incur some expense, but that also may be true for after-tax IRAs.
"Keeping track of basis through the years may add to costs," King says.
Suppose Jane puts $50,000 into an after-tax IRA over a period of years, and the account grows to $75,000. She then withdraws $9,000 from this account, her only IRA.
Her account is two-thirds after-tax money ($50,000) and one-third untaxed earnings ($25,000), so two-thirds of Jane's withdrawal ($6,000) will be untaxed, while one-third ($3,000) will be taxable.
PILING ON THE PAPERWORK
"When making non-deductible IRA contributions, Form 8606 must be filed and records must be meticulously maintained," says Tracy Dalton, an attorney and CPA who is senior vice president and wealth fiduciary services manager at Johnson Bank in Racine, Wis. "When distributions are made, the amount treated as non-taxable is the ratio of total non-deductible contributions to the value of all IRAs, even those IRAs in other accounts."
Going forward, distributions of after-tax dollars must be tracked, and the ratio of after-tax to pretax money must be recalculated.
Advisers might address some of these concerns by suggesting a possible Roth IRA conversion.
Say Jane contributes $6,500 to an after-tax IRA and converts to a Roth when the balance is $6,500. If she has no other IRAs, she will owe no tax.
Such back-door conversions may allow high-income clients to make annual Roth IRA contributions.
"Back-door Roths may be beneficial, but they have other risks," Dalton says.
"Unexpected taxes may result if the client has other IRAs," she says. "Because this not a statutorily defined technique, it invites scrutiny by the IRS."
Just as the tactic isn't legally defined, neither is the waiting period between the transactions. To be prudent, advisers might caution clients to wait for paperwork showing the traditional IRA contribution before executing the Roth conversion.
This story is part of a 30-30 series on tools and strategies for retirement.