) -- 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:

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) - Get Report

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


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 This means we have 5% of the $5,000 withdrawn tax free.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equation through to the end, the nondeductible assets will not be exhausted from that account until the last dollar is withdrawn from all of your IRAs.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If someone does not account for the nondeductible assets for the life of the accounts, it may become double taxed when withdrawn.

There are two possible fixes to consider:

  • Convert all IRAs to Roth IRAs and pay taxes on the entire taxable portion. If you have large IRA balances, this may be unacceptable.
  • This next fix is completely tax free, but takes some work: If you are working and have a 401(k), or you have a business and can start a 401(k), ask if you can roll over your IRAs into the 401(k). If you can, roll them into the 401(k) minus the basis, which must be left behind in the IRA. Now that the IRA has isolated the nondeductible assets, they can be tax-free converted to a Roth IRA. In the next calendar year, the rollover money from your 401(k) can be rolled back to your IRA (if the employer allows) and you have the best of all worlds.

Take the example above again in this step-by-step analysis:

Assume I rolled over the $95,000 Fidelity IRA to my company 401(k) plan on May 1. On July 1 I converted the $5,000 Schwab IRA into a Roth IRA. When I did that, my tax return would have shown a $5,000 IRA taxable distribution of all IRA accounts -- but I have a $5,000 basis in my IRA to eliminate the taxation, making the conversion 100% tax free. Then on Jan. 10 I went to my employer and asked if I could do an in-service rollover of my 401(k) money back to an IRA. If it was allowed, I would now have a $5,000 Roth tax-free account at Schwab and a $95,000 Fidelity Traditional IRA account with no tax consequences.

If you have nondeductible IRA assets, I strongly recommend you figure out how to get it rolled over to a Roth IRA so a half-century of accounting does not have to take place to avoid double taxation.

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Andrew Tignanelli, CFP, CPA, is president of

Financial Consulate

, based in Hunt Valley, Md., and a member of NAPFA, the National Association of Personal Financial Advisors.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.