Traditional IRAs and Roth IRAs are fantastic retirement accounts, but not everyone is allowed take advantage of the tax benefits they offer.
Roth IRAs are completely off-limits once you reach a certain level of income. And your ability to deduct contributions made to a traditional IRA is limited if you or your spouse participate in an employer retirement plan and you make a certain amount of money.
In other words — mo’ money, mo’ problems.
If that’s your situation, what can you do? One option is to make a non-deductible contribution to a traditional IRA. Here’s how it works:
- You contribute to a traditional IRA, just like you would if you weren’t in this position.
- Unlike most traditional IRA contributions, your contribution is NOT deductible for tax purposes.
- Your investments grow tax-free while inside the account.
- When you make withdrawals, the earnings are taxed as ordinary income, while the amount you’ve contributed is tax-free.
You don’t get the full benefit of tax deferral that you do with a traditional IRA. And you don’t get the full benefit of tax-free withdrawals that you do with a Roth IRA. But you do get to defer taxes on the growth of your investments, potentially for a number of decades.
So, is a non-deductible IRA worth it? Let’s figure it out.
Quick note: This is a complicated tax issue, and you should absolutely consult with a qualified CPA before making any decisions here.
Downsides to a Non-Deductible IRA
Clearly, a non-deductible IRA isn’t as good as a traditional IRA or Roth IRA. And in most cases it isn’t as good as other retirement accounts, like a 401(k) or even a health savings account. If those options are available, it’s almost always best to maximize them first before even considering a non-deductible IRA.
But even if you’ve used up all those other options, there are still some things to watch out for.
The biggest is that even though your contributions won’t be taxed again, withdrawals from a non-deductible IRA may be subject to more taxes than you think.
The reason is that the IRS considers all of your IRAs to be one big pot when it figures out how to tax your withdrawals. So even if you have multiple IRAs, the IRS doesn’t look at it that way, and that can cause some problems.
Here’s an example.
Let’s say you have $10,000 in a non-deductible IRA. $5,000 of that is from your contributions and $5,000 is from investment growth.
If you withdraw that $10,000 in retirement, you might expect that half of it would be taxed and half of it wouldn’t. And that’s exactly how it would work if that’s your only IRA.
But now let’s say you also have $90,000 in a different, traditional IRA, all of which has been deferred and eventually needs to be taxed.
Now when you make that same $10,000 withdrawal from your non-deductible IRA, the IRS actually views it as $10,000 being withdrawn from a total $100,000 IRA pot. And because only $5,000 of that, or 5%, represents your tax-free contribution, only 5% of your $10,000 withdrawal will be tax-free.
Instead of getting $5,000 tax-free, you only get $500 tax-free because of your other IRA. The rest of that $10,000 withdrawal will be taxed.
As far as the IRS is concerned, you’ll still have $4,500 of tax-free withdrawals available to you within your IRA, so it doesn’t go to waste. It’s just that it will be used in small chunks over time as you make IRA withdrawals instead of being available to you all at once.
Why Would You Ever Use a Non-Deductible IRA?
Given that rule, the non-deductible IRA is pretty limited in its usefulness. But there are still some situations in which it can make sense.
Here are a few of them, again with the big caveat that all of this depends on your specific tax situation. You should definitely consult with a qualified CPA before doing any of these.
1. Conduit for a Backdoor Roth IRA
The backdoor Roth IRA is one of the shadier-sounding things in the world of personal finance, but it’s a perfectly legitimate way for you to contribute money to a Roth IRA even if you exceed the income limits.
It’s basically a two-step process:
- Make a non-deductible contribution to an IRA.
- Convert that money to a Roth IRA.
It works because anyone is allowed to convert a traditional IRA to a Roth IRA, regardless of income. And because your original contribution was non-deductible, there will be little-to-no taxes to pay on the conversion.
There are pitfalls to avoid, especially if you have other IRAs, but in the right situation it can be a fantastic move.
2. Could Be Better Than a Taxable Account
Assuming you’ve already maxed out all your dedicated retirement accounts, the main alternative to a non-deductible IRA is a taxable investment account.
The downside of a taxable investment account is that you don’t get tax-free growth, though you can choose tax-efficient investments that maximize deferral.
The upside of a taxable investment account is that most or all of your earnings will be taxed at the lower capital gains tax rates, rather than taxed as ordinary income.
So, which is better? Tax-deferred growth or lower tax rates at withdrawal?
The answer depends on the specifics of your situation and the assumptions you make about the future. I tend to lean towards a taxable account simply because the comparison is usually close and a taxable account avoids all the confusion we talked about above. But this calculator can help you run the numbers yourself to compare a non-deductible IRA with a taxable account.
3. Holder for Tax-Inefficient Investments
Certain types of investments, like real estate investment trusts (REITs), are inefficient from a tax perspective. They distribute most or all of their gains each year, meaning that it’s difficult or impossible to defer the growth within a taxable account.
If you want to have tax-inefficient investments in your portfolio, and if you don’t have room for them in your dedicated retirement accounts, holding them in a non-deductible IRA could be a good idea simply for the tax-free growth it offers.
How to Make Non-Deductible IRA Contributions
If you’d like to make a non-deductible IRA contribution, the process itself is pretty straightforward:
- Open a new traditional IRA account. You don’t have to do this, and again it doesn’t matter to the IRS, but having your non-deductible contributions separate from your deductible contributions can be helpful for your own record-keeping purposes.
- Contribute to the IRA. You don’t need to indicate that it’s a non-deductible contribution or anything like that.
- File Form 8606. When you do your taxes, you’ll need to file Form 8606 to indicate that you’ve made a non-deductible contribution. Make sure to keep copies of all these forms for yourself, too, as this is the only proof you have that you’re entitled to tax-free withdrawals of those contributions.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.