A traditional IRA lets you make tax-deductible contributions to a retirement account that grow tax-deferred until you’re ready to start taking distributions in retirement. It’s a popular option for many savers, but it doesn’t work for everyone. One alternative is the non-deductible IRA, which lets high earners get in on the IRA action. Let us explain how it works and who can benefit.
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Why a Non-Deductible IRA?
A traditional IRA gives savers the benefit of making tax-deductible contributions, but not just anyone can write off their IRA contributions. The IRS won’t let you deduct your IRA contributions if your income is over certain limits. That’s because the government doesn’t want wealthy people to take advantage of too many tax-deferred investment vehicles.
IRS limits for deductible IRA contributions depend on how you file your taxes (singly, married joint, married separate), your income and whether you also save pre-tax dollars through work (in a 401(k), for example).
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Bottom line? Depending on your circumstances, you may be ineligible to deduct IRA contributions. For example, according to the 2015 limits, a married couple filing jointly who both save in employer-sponsored retirement plans and who have a combined adjusted gross income (AGI) of $118,000 or more cannot make deductible IRA contributions. That’s where a non-deductible IRA comes in.
The idea behind a non-deductible IRA is to bring the benefits of tax-deferred growth to the folks who are ineligible to save in a regular IRA. Folks like our hypothetical wealthy couple. You can make non-deductible contributions to a pre-exisiting IRA, or open a separate IRA just for non-deductible contributions.
Non-Deductible IRAs and Backdoor Roth Conversion
Often, a non-deductible IRA is just a layover on the flight from taxable income to a Roth IRA. Like traditional IRAs, Roth IRAs have income limits. But many rich people want Roth IRAs anyway, drawn to their tax advantages. With a Roth IRA, you save after-tax dollars now, enjoy tax-free growth and take tax-free distributions in retirement. Who wouldn’t want in on that action?
So, what’s a high-income saver to do? Answer: The Backdoor Roth. It’s got a slightly shady name, but it’s perfectly legal. If your income leaves you locked out of the Roth option, you can simply contribute to a non-deductible IRA and then convert that IRA to a Roth IRA. Voila! You’ve got a Roth.
One caveat: the backdoor Roth is not necessarily tax-free. Say you’ve made both deductible and non-deductible contributions to IRAs over the years, and now you want to convert your non-deductible IRA to a Roth.
To figure out your tax liability, take your after-tax contributions and divide them by the total value of all your IRAs. If you have $5,000 worth of non-deductible contributions and $15,000 worth of deductible contributions from back when your income allowed you to contribute to a deductible IRA, only 25% (5,000/20,000) of your backdoor Roth conversion will be tax free. 75% of the money you convert is taxable. If that’s not enough tax advantage for you, you can “hide” your deductible IRA contributions from the IRS by rolling them into a 401(k). Got all that?
Related Article: Which Type of IRA is Right For You?
The Risks of a Non-Deductible IRA
Non-deductible IRAs that are promptly converted to Roth IRAs can be great. Permanent non-deductible IRAs, on the other hand, have some risks.
If you don’t keep separate IRAs for your deductible and non-deductible contributions, you could end up paying more taxes than you should. That’s because once you’ve blended deductible and non-deductible contributions, it’s hard to keep the two straight.
It can be done – as long as you keep track of your contributions. You’ll then have to divide your non-deductible contributions by the total contributions to all IRAs in your name to get a percentage that represents your after-tax contributions. You don’t have to pay taxes on this percentage of the growth in the account when you start taking deductions. Your after-tax contributions to IRAs are known as your basis.
You can (and should) file Form 8606 for each year that you make after-tax contributions to a non-deductible IRA. That way, you’re giving the IRS a record of your contributions that they can use to calculate your tax burden in retirement.
Remember that when you start taking distributions in retirement, that money will be taxed according to your income tax bracket. If you’re a high earner, that rate will be, well, high. You might be better off parking your money in a taxable account that uses tax loss harvesting to beat the Tax Man. Why? Because the tax rate on long-term capital gains is lower than the income tax rate for high-income saver.
Related Article: Getting Started with Retirement Planning
If you’re a high-income saver looking to maximize your tax advantages, contributing to a non-deductible IRA on your way to a backdoor Roth conversion could be a great way to set yourself up with a tax-free source of retirement income. But if you’re thinking about parking your money in a non-deductible IRA for the long term, it’s important to weigh the risks.
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