What Is A Nondeductible IRA?
If you are planning for your retirement (if not, you should be), you are probably already familiar with the concept of an IRA. Financial experts generally agree that you should enter retirement with the ability to cover 75% or more of your pre-retirement income. And that can be a pretty hefty ask, especially in a modern world where many of us live paycheck to paycheck or don’t have much leftover at the end of the month to put into our savings.
IRAs bring many advantages as they allow you to save for your retirement with growth that is tax-free or tax-deferred. The three primary types of IRAs are:
- Traditional IRA – This is the most common type of IRA. For these accounts, you make contributions with money that you can then deduct on your tax return. Then, any earnings can grow tax-deferred until you withdraw them post-retirement. And, since most retirees are in the lower tax-bracket come retirement, this means that they are generally taxed at a lower rate than the rate they often paid during their working years.
- Roth IRA – With these accounts, you make contributions with funds that you have already paid taxes on (after-tax). In most cases, your money can then grow tax-free and you can withdraw the money without tax penalty. Unfortunately, contributions to a Roth IRA are limited by income.
- Rollover IRA – These accounts are those that are created when you contribute funds that have been rolled over from a retirement plan into a traditional IRA. In most cases, this happens when you leave an employer and start with a new one.
A non-deductible IRA, however, is most similar to a traditional IRA with the exception that you cannot deduct your contribution from your income taxes. This means that the money that you could have saved on those years and years of tax deductions could have been compounding over the years, making you more money. The great news, however, is that you can avoid capital gains as well as dividend taxes when your money grows.
The benefits of a non-deductible IRA
Whenever possible, the ideal scenario is that you contribute to a traditional IRA or a Roth IRA. But, in some situations, you may find that a non-deductible IRA is the right course of action for you.
You have a high income: If your income is in the higher tax bracket, you won’t have the opportunity to deduct much of anything, if anything at all, on your income taxes if you use a traditional IRA. This is true if you are single and have a modified adjusted gross income of $72,000, or if you are married and filing jointly with a modified adjusted gross income of $119,000 or more.
Your spouse is the only one of you that has a work-sponsored retirement plan: Your spouse’s retirement savings plan could put you in a high tax bracket if you are married and filing jointly. This can make it difficult for you to take advantage of the traditional IRA deduction. If the combined income of you and your spouse is over $186,000, a non-deductible IRA might be the better solution.
Tax-Free Gains: The notion of a non-deductible IRA is that the contributions are made without the preliminary tax break and can grow without additional taxation. However, in the event you have both deductible as well as nondeductible IRA contributions, only a chunk of the gains may be tax-free.
The avenue to a Roth IRA: If your income is too high for you to qualify for a Roth IRA, you may be able to contribute to a non-deductible IRA and later convert that account to a Roth IRA. However, there are tax implications with this method. As such, this approach is often called the Backdoor Roth IRA. This said, it can be a great option for high-income wage earners who would like the opportunity to contribute to a Roth IRA.
Options: There are many reasons that you may not meet the qualifications to make deductible IRA contributions. Generally, your income is the biggest reason. However, you might find that your income is higher than the allowed income limits when you combine your income and your spouses, even if only one of you has an IRA account. You might also be affected by your workplace retirement plan. Whatever the circumstances are in your situation, a nondeductible IRA can allow you to contribute in some way despite your income level.
The Non-Deductible IRA Basics with the Internal Revenue Service (IRS)
A nondeductible IRA has the same contribution limits and is subject to the same rules as a Traditional IRA. The significant difference between the two is how the contribution is treated on your annual tax return. You can proceed with non-deductible IRA contributions to the same IRA account that has deductible contributions, however, for tracking and to stay organized, it is best to maintain a separate account for all non-deductible contributions.
With your annual tax return, you will need to file a form 8606. With this form, you will report the amount of your IRA contribution that is non-deductible. Those who earn higher incomes can leverage non-deductible IRAs to contribute to a Roth IRA, making it a very effective strategy for those in that situation.
As mentioned previously, aside from how contributions are taxed, traditional and non-deductible IRAs work in the same manner. You can make non-deductible contributions into your traditional IRA in which you have previously made deductible contributions. Traditional and nondeductible IRAs have the same total contribution limits. However, you must have accepted taxable income during the same contribution year and contributions must cease when you achieve age 70 ½, as this is the age where you will be required to draw preliminary funds out of your IRAs.
Tax-Free Growth for Non-Deductible IRAs
Though the goal is for a non-deductible contribution to grow without further taxation, any deductible contributions that you have made to any of your IRA accounts will have an impact on your non-deductible earnings potential. The percentage for each IRA is calculated based on all IRA holdings.
The Non-Deductible IRA may be a last resort
Many investors and pending retirees consider a non-deductible IRA as an absolute last resort. The challenge with non-deductible IRAs is that non-deductible contributions are determined using a calculated percentage of all IRA holdings. This can really eat away at your savings growth.
The additional filing form of the 8606 and associated penalties for any omissions can add complications in using a non-deductible IRA for retirement planning purposes. Though a non-deductible IRA is a solid option for those making only non-deductible contributions, it isn’t likely the best choice for those with ample deductible contributions already put away.
Regardless, it is highly suggested that you contribute as much as you can to your workplace retirement plan. Be sure to contribute at least what is required to obtain the employer match. Whenever possible, contribute at the maximum level possible. This will ensure that you are on a good path to retirement. And when you have maxed out all other options, then it is time to lean on a non-deductible IRA to continue growing your retirement savings.