Saturday, 23 September 2023
Updated on Monday, November 29, 2021
A nondeductible IRA is a way of making contributions to an individual retirement account, not a specific type of IRA.
Anyone can contribute money to a traditional IRA, no matter how much they make. But you can only make tax-deductible contributions to a traditional IRA if your modified adjusted gross income (MAGI) is below certain limits set by the Internal Revenue Service (IRS). Meanwhile, Roth IRAs are only available to people whose income is below certain thresholds.
Non-deductible IRA contributions make sense for your retirement planning only when your annual income exceeds the limits for a traditional IRA or a Roth IRA.
A nondeductible IRA strategy is when you contribute money to a traditional IRA but don’t get the tax deduction benefits, says Garrett Konrad, chief operating officer at registered investment advisory firm IFC.
Tax deductions reduce your annual taxable income, thereby lowering your tax bill or increasing your tax refund. Contributions to a traditional IRA are partially or fully deductible, depending on your income, filing status, and whether you’re covered by a retirement plan through your employer. For 2022, you can deduct your entire contribution to a traditional IRA if:
If your tax filing status or income puts you out of range of the traditional IRA caps outlined above, that’s when you make non-deductible IRA contributions.
Alternatively, you might consider a non-deductible IRA if your income makes you ineligible for a Roth IRA. Roth IRAs provide tax-free distributions in retirement, but you can’t contribute to one if your annual income is too high. For 2022, you can’t contribute to a Roth IRA if:
Non-deductible IRA contributions are part of the backdoor Roth IRA strategy (more on that later). Just keep in mind that non-deductible IRAs are subject to the same maximum contribution limits as traditional and Roth IRAs. For the 2022 tax year, you can contribute up to $6,000 to either type of IRA, or $7,000 if you’re age 50 or older.
A nondeductible IRA allows you to defer taxes but not escape them completely. After you pay taxes on your income, you can make nondeductible IRA contributions to a traditional IRA. The contributions will not be taxed when you withdraw them in retirement, because you’ve already paid income taxes on them. However, you will owe income taxes on the earnings you withdraw from the account.
“Because it is a type of contribution, not a type of account, you need to be careful when non-deductible IRA contributions get mixed into an account that previously had tax-deductible contributions in it,” Konrad said. “Tax-deductible contributions are taxed upon withdrawal on the entire amount, while non-deductible contributions are only taxed on the growth of the contribution.”
Take a simplified example of a traditional IRA that has $1,000 in deductible contributions and $1,000 in non-deductible contributions. Assuming each contribution grows by $100, the account balance would be $2,200.
If you were to withdraw the entire deductible contribution, the $100 in earnings from the deductible contribution, and the $100 in earnings for the non-deductible contribution, this $1,200 sum would be taxed. A withdrawal of the $1,000 non-deductible IRA contribution would be not taxed.
Now imagine that you have decades of deductible and non-deductible contributions — plus earnings from both sorts of contributions — in your traditional IRA. You can imagine how managing your portfolio’s taxes would become tricky once you begin taking distributions in retirement.
There’s another factor to be aware of: Non-deductible IRA contributions are subject to required minimum distributions or RMDs. With traditional IRAs, including those that hold non-deductible contributions, the IRS requires you to begin taking money from your account at age 72, the so-called RMDs.
The amount you’re required to withdraw is based on your account balance and life expectancy. If you don’t take your RMDs on schedule, the IRS can hit you with a steep tax penalty of 50% of the amount you were required to withdraw.
The most popular reason for making non-deductible IRA contributions is because you’ve exceeded the income limits to deduct traditional IRA contributions or because you can’t contribute to a Roth, says Adam Bergman, president of the IRA Financial Trust and IRA Financial Group in Miami.
Even if you’re not able to deduct your contributions for the year or contribute to a Roth, a non-deductible IRA allows you to fully utilize an IRA as part of your retirement strategy. You can still max out the annual contribution limits this way, meaning you have more money in your IRA that can grow as a result of compounding interest.
The other reason to make nondeductible IRA contributions is as a stepping stone to a backdoor Roth IRA, says Jonathan Bednar, a certified financial planner at Paradigm Wealth Partners in Knoxville, Tenn.
A backdoor Roth IRA is a way to get a Roth IRA and enjoy its tax benefits when you’d otherwise be ineligible for the account due to an income level that was above the IRS thresholds outlined above.
To execute a backdoor Roth IRA, you’d first open a traditional IRA and then make a non-deductible IRA contribution. Next, you convert it to a Roth account. If done immediately after making the non-deductible contribution, there’d be no taxes owed and you could reap the benefits of tax-free distributions of a Roth IRA once you retire.
However, you do have to watch out for the pro-rata rule, Bergman says. This rule dictates that if you have both pretax and after-tax contributions in your IRAs, you have to use the aggregate balance to determine how much tax you’ll owe when you convert to a Roth account.
Also, keep in mind that if you’re converting your entire traditional IRA, including both deductible and non-deductible contributions, all of the money would be taxable in the year you make the conversion. This can temporarily increase your tax liability, so it’s important to ensure you have cash on hand to cover any taxes owed associated with a Roth conversion.
A nondeductible IRA isn’t the best approach for every investor when planning for retirement. Making non-deductible contributions to an IRA usually only makes sense in one of two scenarios.
“There is really no good reason to make an after-tax contribution other than not being able to make either a pre-tax or Roth IRA contribution,” Bergman said. “The after-tax contribution does not include a tax deduction and does not have tax-free growth as a Roth IRA.”
Making non-deductible IRA contributions could come in handy if you’ve experienced a life event that changes your tax profile, such as getting a substantial raise at work. You wouldn’t be excluded from making IRA contributions based on your income. At the same time, you could further grow your retirement wealth by maxing out your retirement contributions at work.
More importantly, adding money to a non-deductible IRA could be a good choice if you’d like to include a Roth IRA in the mix when planning for retirement. Along with tax-free distributions, the other benefit of a Roth is the ability to avoid RMDs. This means that your money can continue growing indefinitely in retirement until you need to begin withdrawing it.
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Source: https://www.magnifymoney.com/blog/investing/non-deductible-ira/
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