Basically, if you’re looking for the type of retirement plan that you can fund using money that you’ve already paid taxes on, then you’d want to set up a nondeductible IRA. With a traditional IRA, you have the ability to use your income tax to deduct contributions. This is not the case with a nondeductible IRA. But when you grow money in a nondeductible IRA via contributions, this is money that is going to continue to grow that you will never pay taxes on.
Throughout this article, we will take time to explain the nondeductible IRA in greater detail. You can use this information to determine if it’s the right choice for you. So stick around to discover the truth.
Nondeductible IRA Benefits
When people are disqualified from traditional IRAs for one reason or another, they tend to turn to the nondeductible IRA because it provides access to a high-quality savings vehicle for their retirement.
As an example, when you invest in this type of an account any of the dividends and capital gains earned from contributions will never be taxed. And in certain cases, all or a part of the money you withdraw from the fund is going to be tax-free. It’s illegal for the government to tax your retirement account twice, which makes this tax-free growth possible.
You may or may not be eligible for a nondeductible IRA contribution based on the rules that we will go over. You can use this information to decide if this is the right retirement option to meet your needs.
Being eligible for a nondeductible IRA is determined based on your tax filing status, your income, if you have another retirement plan in place from your workplace – you might be ineligible even if you have a plan that you do not use. They’ll also make this determination by whether or not your spouse has a 401(k) or another retirement plan as well.
Obviously, this whole situation can become quite complicated. So we will now go over the basics in greater detail.
Eligibility Requirements & Rules for Nondeductible IRA Consideration
A single person without a spouse can receive eligibility for tax-deductible IRA contributions to a traditional IRA depending on their MAGI also known as the modified adjusted gross income. After a certain point, you’ll only be able to deduct part of your contributions until the time your income reaches a certain level. Once you get to this point, you will not be allowed to deduct contributions from your income tax. Each year, the IRS sets the level. As an example, for the tax year 2019, it’s not possible to deduct full contributions until your modified adjusted gross income is more than $64,000. And on the flip side, you will not be able to deduct after your income is more than $74,000.
If a married couple files jointly, eligibility is determined based on income and whether or not one spouse has a workplace retirement plan available.
To make this simpler, we will break it down based on who has the retirement plan. Once your income surpasses the initial amount, only part of your contributions is tax-deductible. And you aren’t allowed to deduct anything after you breached the second amount.
- $103,000 – $123,000 when you have a workplace retirement account
- $193,000 – $203,000 when your spouse has a workplace retirement account and you don’t
Backdoor Roth Conversion & Nondeductible IRAs
In many instances, people will use a nondeductible IRA if they are no longer eligible to contribute to their Roth IRA, because just like a traditional IRA, there are income limits to making Roth IRA contributions.
A 2019 example is your modified adjusted gross income is more than $137,000 as a single person or a jointly filing married couple is more than $203,000.
What does somebody with high income looking to save do? They consider a backdoor Roth. The name may seem shady on the surface, but this is a legal way to save your income. If you are ineligible for a traditional or Roth IRA, you can use a nondeductible IRA and then convert it to a Roth IRA. That’s how you make Roth IRA contributions when your income is too high!
One thing to note: using this backdoor Roth technique doesn’t necessarily mean it’s going to be a 100% tax-free. This can get really tricky so if you’re struggling with this, definitely talk to an accountant. But here’s an example to help you better understand.
If you have contributions in the amount of $5000 in a nondeductible IRA and $15,000 in contributions from a time when you made deductible IRA contributions, you’ll only be able to maintain 25% of your backdoor Roth contributions as tax-free. The other 75% of the contribution is going to be taxable.
This is very tricky to say the least but this conversion is also quite rewarding. If you are struggling, contact a financial advisor to get help from someone who better understands the pitfalls and rules of this investment type.
Nondeductible IRA Risks
When you can immediately convert your nondeductible IRA to a Roth IRA this is a great investment opportunity. Nondeductible IRAs that are permanent do have certain risks though.
As an example, if you somehow failed to separate your nondeductible and deductible contributions, it’s very possible that you’ll end up paying more taxes than you initially intended. Because you blended these contributions, it’s very hard to keep straight the two different options.
But it certainly is possible – you just have to be meticulous when tracking your contributions. You need to divide contributions that are nondeductible by your total contributions to every one of your IRAs to determine the right percentage that represents the contributions that you’ve made after taxes. Because you aren’t supposed to pay taxes on income that was already taxed.
You should make it a point to file form 8606 every year when you make after-tax contributions to an IRA that is nondeductible. By filing this form, the IRS will have a record of these contributions on hand which they can use to help calculate your taxes when you are retired.
When you begin taking retirement distributions, you will have to begin paying taxes based on your tax bracket. If you earn a high amount of money, this is going to be an elevated tax rate. In fact, putting your money in a taxable account with tax loss harvesting might be a better option. Long-term capital gains taxes are more favorable than high income tax rates.
Do you earn a large income? Are you looking to save money for your retirement? Are you hoping to make the most of the current tax advantages? Making nondeductible IRA contributions is the best way to initiate backdoor Roth conversion and protect your retirement savings from additional taxation. But you definitely need to weigh the risks if you’re thinking about making long term nondeductible IRA contributions so definitely keep that in mind.
Preparing for Retirement
- Determine the amount of money you’ll need to retire in comfort. If your employer offers 401(k) matching take advantage of it.
- Contact a financial advisor. They will help you get your retirement goals on track so you can retire comfortably when the time comes to leave the workforce for good.
If you liked this article, make sure to come back soon and check out my latest updates. I have some very solid guest contributors coming to add a lot more depth to the site in coming months, so stand by, you are in for a real treat.