A non-deductible IRA is a retirement plan you fund with after-tax dollars. So you can’t deduct contributions from your income taxes as you would with a traditional IRA. However, your non-deductible contributions grow tax free. Many people turn to these options because their income is too high for the IRS to let them make tax-deductible contributions to a regular IRA. This article will explain all you need to know about a non-deductible IRA and whether one is right for you. We can also help you find a financial advisor who would guide you through making the retirement planning decisions that are right for you.
Check out our retirement planning calculator.
What Are the Benefits of a Non-Deductible IRA?
Most people turn to non-deductible IRAs because certain circumstances disqualify them from making tax-deductible contributions to traditional IRAs, but they still want access to a reliable retirement savings vehicle.
For instance, any capital gains and dividends your contributions produce won’t be taxed while invested in the account. In some cases, all or a portion of the money you withdraw would be tax-free. That’s because the government can’t tax your retirement savings twice. More on that later, but first, let’s cover the rules to see if you’re eligible to make non-deductible IRA contributions. This will also help you decide if this is a good option for you.
Your eligibility to deduct some or all of your IRA contributions from federal income tax depends on your income, tax-filing status and whether you have access to a workplace retirement plan (even if you don’t participate in the plan). Whether your spouse participates in an employer-sponsored retirement plan such as a 401(k) can affect your eligibility as well.
It can get complicated, so let’s start with the basics.
Non-Deductible IRA Rules and Eligibility Requirements
If you’re single, your eligibility to make tax-deductible contributions to a traditional IRA depends on your modified adjusted gross income (MAGI). Once it exceeds a certain point, you can deduct only a portion of the contributions you make until your income reaches a level. At that point, you can’t deduct any of your contributions from your income taxes. The IRS sets these levels each year. In 2019, when your MAGI breaches $64,000, you can’t deduct your full contributions. Additionally, you can’t deduct any money once your income surpasses $74,000. For 2020, you can’t deduct your full contributions once your MAGI breaches $65,000. You can’t deduct anything once your income surpasses $75,000.
If you’re married filing jointly, your eligibility to make tax-deductible contributions depends on your income and whether one of you participates in a workplace retirement plan.
To simplify, we summarize the 2020 rules based on who has a workplace retirement plan below. When income exceeds the first number, only a portion of contributions can be tax deductible. Once it surpasses the second number, you can’t deduct anything.
- You have a workplace retirement plan: $104,000 – $124,000
- You don’t have one, but your spouse does: $196,000 – $206,000
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.
For 2019, you can’t contribute to a Roth IRA if your MAGI exceeds $137,000 as a single filer or $203,000 as a married couple filing jointly. For 2020, you can’t contribute if your income exceeds $139,000 as a single filer or $206,000 as a married couple filing jointly.
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 100% tax-free. Say you’ve made both deductible and non-deductible contributions to IRAs over the years. If now you want to convert your non-deductible IRA to a Roth, you’d have to pay income tax on a portion of this.
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. So 75% of the money you convert is taxable.
As you can see, the backdoor Roth conversion can be as tricky as it is rewarding. So it’s best to seek the help of a financial advisor. That way, you can make sure you follow all the rules and avoid pitfalls that may be waiting around the corner.
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 deductible and non-deductible contributions separate, 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.
You can do it, though – so 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 federal 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 the government entity can use to calculate your tax burden in retirement.
Remember that when you start taking distributions in retirement, you’ll have to pay money on that money according to your income tax bracket. If you’re a high earner, that rate will be elevated. You might be better off parking your money in a taxable account that uses tax loss harvesting. Why? Because the tax rate on long-term capital gains is typically lower than the income tax rate for a high-income saver.
Say 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 protect some or all of your retirement savings from taxation. 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.
Tips for Getting Retirement Ready
- Figure out how much you’ll need to save in order to retire comfortably. An easy way to get ahead on saving for retirement is by taking advantage of employer 401(k) matching.
- Work with a financial advisor. People who work with financial advisors are twice as likely to be on track to meet their retirement goals, industry experts say. You can use our financial advisor matching tool to find a qualified professional near you. After answering some questions about your retirement goals, the tool will connect you with up to three local advisors. Moving forward, you can access their profiles and review their qualifications before deciding to work with one.
Photo credit: flickr, ©iStock.com/ClarkandCompany, ©iStock.com/RoBeDeRo