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The Non-Deductible IRA Trap -- and the Fix

HUNT VALLEY, Md. ( TheStreet) -- If you don't have any nondeductible IRA assets, this article will not be of interest to you. If you have ever made nondeductible IRA contributions, get ready to be shocked!

Nondeductible IRA assets happen when you are ineligible for an IRA deduction but make an IRA deposit. There is no limitation to make a deductible IRA deposit if you and your spouse (if applicable) don't have a pension plan at work. If you or your spouse has a pension, there are income limitations to deducting IRA deposits. In addition, every year after you make a nondeductible IRA contribution you must file a form 8606 to disclose your basis in an IRA. Here's an example:

IRA
If you have ever made nondeductible IRA contributions, you should start thinking about the lowest-taxed way to get your money out.

Let's say you deposited $5,000 in an IRA with Charles Schwab (SCHW) in 2007 and found out it was nondeductible after you filed the form 8606 to disclose your basis. The next year you roll over $95,000 from your former employer's retirement plan to a Fidelity IRA. In 2011 you took the entire amount out of the Schwab IRA and it was still worth $5,000. What is the tax consequence of the $5,000 distribution from the Schwab IRA?

Most would say it is tax free, since there was no tax deduction when it was deposited in 2007, but that is where the problem begins. You must combine all outstanding IRAs as a denominator and use the basis from your IRS-filed form 8606 as the numerator and the percent derived is the only nontaxable portion.

Take our example above. All IRAs outstanding (the denominator), assuming zero growth, is $100,000 ($95,000 at Fidelity and $5,000 at Schwab). The numerator is the $5,000 from the form 8606 basis. This means we have 5% of the $5,000 withdrawn tax free. Therefore $4,750 is taxable and $250 is tax free on any $5,000 withdrawal regardless what account it came from. If you carry that equation through to the end, the nondeductible assets will not be exhausted from that account until the last dollar is withdrawn from all of your IRAs. This could easily be 10, 20 or even 50 years. If someone does not account for the nondeductible assets for the life of the accounts, it may become double taxed when withdrawn.

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