I decided to fund a traditional IRA in January. The IRS limit for an IRA contribution in 2016 is the same as 2015: $5,500, plus a $1,000 “catch-up” amount for those of us barely older than 50, for a maximum contribution of $6,500. You must have earned compensation and be younger than 70 years, 6 months. Earnings are not taxed until distributions are made.
My decision to fund an IRA was automatic: I’ve done this every January for 20 years. This year I felt I was buying low, because the market in January was down almost 15 percent from its May/June peak, and the stock mutual-fund investments within the IRA were correspondingly down in price. (The market has fallen further since.)
Retail investors tend to get nervous when markets decline. Just about every other retail item or commodity exhibits rising demand during price declines, in what economists refer to as price elasticity. But that is rarely the case with stocks.
Many investors stopped funding IRA accounts when the tax law changed and limited deductibility of the contributions. I fund, because the money cannot be taxed further until retirement, thereby removing it from the 1099 completely during my earning years.
The tax-free compounding is also an advantage. Despite a dreadful start to the New Year in financial markets, I’m confident, but not certain, that markets will be higher during retirement when I actually need the money.
Nondeductible IRA contributions create something called basis in the IRA. Basis is short for tax basis — the contribution has already been taxed once, so getting your basis back in future distributions is not recognized as taxable income on distributions. Your accountant can help track the basis during your working years, but you must file an extra tax form each year you make nondeductible contributions and keep track to enjoy the benefits during retirement. Check with a certified public accountant to run a calculation before implementing this strategy.
IRA basis can also be handy when converting a traditional IRA to a Roth IRA. While you must pay tax on the amount converted for that tax year, the basis is excluded from the tax calculation. This could be an effective strategy during bear-market declines of 20 percent or more. The advantages of Roth IRAs are legend, but more about that in a future column.
Will my January investment in a nondeductible IRA pay off during retirement? I’ll let you know in about 15 years.
Mark Daly is managing director, investment officer, Daly & Vachek Investment Consulting Group of Wells Fargo Advisors. dvicg.com; (208) 333-1433. This column appears in the Feb. 17-March 15, 2016, edition of the Idaho Statesman’s Business Insider magazine.