Should I Make Non-Deductible IRA Contributions?

Non-deductible contributions to a Traditional IRA usually aren’t the most exciting financial move one can make.  But like every financial strategy, it has its place and can be effective for the right person under the right set of circumstances.  Although not as exciting as a deductible IRA, earnings from the non-deductible IRA remain sheltered from income taxes until withdrawn.

Generally, deductible Traditional IRA contributions are limited if you or your spouse is covered by an employer provided retirement plan.  Meanwhile, Roth IRA contributions are limited as well.  These contribution limitations for these IRA’s are based on your modified adjusted gross income.  As income hits certain levels, the contributions allowed gradually phase out.  However, if you aren’t eligible for a deductible Traditional IRA or Roth IRA contribution, you still may be eligible for a non-deductible Traditional IRA contribution.

A Stipulation

The only stipulation with a non-deductible IRA contribution (or any IRA contribution in general) is that the taxable household needs to have earned income for the year the contribution is made.  Earned income is income that is subject to Social Security taxes.  So if you earned $4,000 in 2010 and are under age 50, then you can contribute up to $4,000, not the maximum contribution limit allowed of $5,000.  But there are no upper income thresholds that limit how much one can contribute to a non-deductible IRA.

Here are some considerations when assessing if making a non-deductible IRA contribution makes sense and what to watch out for:

  • Before even considering a non-deductible IRA, you should be fully funding any employer based retirement plan first.  Second, this is only attractive if you aren’t eligible for a deductible Traditional IRA or Roth IRA contribution.  This should be a consideration once you exhausted these options.
  • This can be an attractive alternative as compared to a variable annuity.  Variable annuities have their place as well.  For example, non-deductible IRA contributions are limited in the dollars you can deposit on an annual basis where there is no contribution limits to a variable annuity.  But usually these products can become expensive as the benefit on the riders that you can buy on these investments usually don’t justify the underlying cost.  In addition, some variable annuities have limited or less optimal investment choices.  This is where you may want to put your next dollars into a non-deductible IRA before considering a variable annuity.
  • For some people who want to invest in a Roth but can’t because of the income limitations, the non-deductible IRA offers a back door strategy.  In 2010, the rules where lifted and now anyone regardless of income can now convert a Traditional IRA to a Roth IRA.  So if you aren’t eligible for the Roth, one can now just contribute to a non-deductible IRA and then convert to a Roth.  Only any appreciation between the contribution and conversion would be taxable as ordinary income (which could be a very small amount if the time frame on the investment has been short).  And voila, you have a Roth IRA.


    This seems pretty simple, but I would offer some caution here.  First, if you already have a Traditional IRA (whether in one or several separate accounts), you can’t just claim that you converted the non-deductible portion and left the other portion alone (even if this was kept in a separate account).  Only the pro-rata proportion of your non-deductible contribution to your total contributions would convert tax free (the rest is taxable).  So if you have significant money already in a Traditional IRA, this backdoor strategy wouldn’t pan out as well.


    Second, there is some grey area in how soon to convert after making the contribution.  There is no clear guidance here from the IRS, but this appears to be an apparent and obvious loophole.  If the conversion is made right after the contribution, I think it would be clear to everyone that the effort was made to skirt the Roth IRA contribution limit rules and it’s always the possibility that the IRS may decide this is a problem too.  I’ve heard several well respected authorities say that doing this immediately is OK.  Meanwhile I’ve seen others strongly advising to wait until the next tax year to convert and risk some capital appreciation and tax cost rather than taking the risk of this being deemed against the rules sometime in the future.  So I would carefully consult your tax adviser if you are considering this.

  • You also need to prepare and retain the proper paperwork with the IRS.  If you make a non-deductible IRA contribution, remember to file a Form 8606 with your tax return.  Failure to file this can result in a $50 penalty although the IRS sometimes will waive this if reasonable cause is shown.  It’s pretty important as failure to file results in the IRS believing that future distributions are fully taxable whereas the proportion that represents earnings only should be taxed as ordinary income.  Also make sure to keep this form in your permanent records as proof of the non-deductible contributions.  This is a Form that could be easily lost or forgotten about after the years pass by; the big risk is paying taxes on dollars that should be tax free.
  • This is an attractive strategy to shelter tax inefficient assets in the headwinds of a higher tax environment in the future.  I’ve seen this to be attractive to the higher wage earner who is maximizing their employer provided plan contributions, but the ability to diversify within the employer based plan is limited.  Most investments that are designed to offset the risk of a stock portfolio tend to be less tax efficient.  A non-deductible IRA is a good way to shelter these tax inefficient assets and further diversify at the same time.

In the end, non-deductible IRA contributions aren’t for everyone, but they are another tool that can be attractive for the right person under the right circumstances.

About the author

Jeffrey N. Bogue, CFP®

35 Comments

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  • If you’ve made non-deductible contributions to a tIRA that now has a combination of both the non-deductible basis and the gains, is it permitted reverse roll over just the gains to a 401(k) thereby leaving only the non-deductible amount for conversion to a Roth?

    Or do the regulations not allow gains in such an IRA to be rolled over to a 401(k) and restrict those only to funds that were originally rolled into an IRA from another 401(k)?

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  • Yes, as years pass by the ability to keep track of the non deductible contributions to the IRA may prove to be a difficult task. With a variable annuity, that is never an issue.

  • Hi Jeff,
    First, this is a GREAT article. I do have a couple of questions:
    For reason too long to go into in this letter, I will be needing to cash-in on a private stock program early. This means I’m going to get hit with captial gain now rather than later, but my concern is what to do with the remaining money. Because our income is too large for a deductible IRA/Roth contribution, I am thinking of maxing out my 401k contribution and on opening a traditional non-deducible IRA for my wife and me and make the max contribution.
    questions:
    – My wife and I are both 50. Can we each make a $6000 contribution?
    – I plan on converting these IRAs to Roth IRAs probable 6 months to 1 year after the contribution. What happens to my 8606 form at that point? Since the fund has been converted, do I still need to keep track of these “non-deductible” funds?

    Thanks again

  • Hi Jeff,

    You wrote that “Only the pro-rata proportion of your non-deductible contribution to your total contributions would convert tax free (the rest is taxable).”

    Is the pro-rata percentage determined by the summed contributions (for the two types of IRA’s} or determined by the current value of the IRA accounts at the time of conversion?

    Thanks.

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  • I am covered/participating in a SEP (employer’s contribution will be $1,250 max). How much if any can I fund into a traditional IRA at age 59? Thanks.

  • I and my wife do not have any Traditional or ROTH IRA yet. We have been investing in 401Ks only. If I open Traditional IRA for 2011, all of my contribution will be non deductibe due to AGI limits. Would I be able to convert Traditional IRA into Roth IRA even if I do not have any deductible contribution in Traditional IRA ?

  • Jeff:

    I participate in a 401k at work, where I am contibuting the max. I also have a IRA rollover account from a former job. In the IRA rollover account, I own some bank stock that was recently awarded some non-detachable warrants. My question is, how do I put some more money into the IRA rollover account incase I want to exercise those warrants in 5 years at which time I will have to have money in the account to pay for the new stock shares? i.e. can I contribute to both my current 401k at work and contribute to IRA rollover account? Are there contribution limits. Thanks!

  • Hi Jeff–

    Thanks for the very informative article. Two questions:

    I have a Traditional IRA comprised solely of 2011 nondeductible, after-tax contributions. My wife has a Traditional IRA that is comprised of pre-tax (401k rollover) contributions. I am planning to convert my traditional IRA to a Roth IRA in its entirety. For purposes of the “cream and coffee” rule, I don’t need to take into account my wife’s IRA (which we’re not planning to convert)?

    Also, in 2010, I converted all of my Traditional IRA holdings as of that time into a Roth IRA and opted to spread the tax bill over 2011-2012. Can I offset my taxable gains from that conversion with losses incurred in 2011 (or with carryforward losses from prior years)?

    Thanks very much,

    DJ

  • Ok, I will handle the last three questions one at a time.

    * To note, what I state below is guidance, but not a definitive answer to your question. Simply put, I’m not able to provide a definitive answer in this type of format; I need to have all of your informtion in front of me to accurately assess this. In turn, you shouldn’t take advice over the internet as this is common sense. So I recommend seeking guidance from a tax accountant and/or financial planner to make 100% sure of your options. But hopefully I can at least give you an relative idea on if your ideas may be potentially feasible. With that, here we go…….

    Tony – The portion of the withdrawal includable as taxable income would be subject to the 10% penalty. Given that you have little in value over your original non-deductible contributions, it sounds to me that the penalty would be minimal. Better check on if you filed those 8606’s for each year; the penalty for this is $50 for each failure to file this form, but you may want to ask the IRS to waive the penalty and hope for leniency. Also I think you would want to file the 8606 in advance of the withdrawal if you decide to do this (tax accountant would help with this).

    Joseph – If you have over $10K in earned income per year, you would be eligible to make a non-deductible IRA contribution for you and your wife ($6K each if earned income is $12k or over and both are over age 50). There is some debate on how quickly you can convert from a non-deductible contribution to a Roth. From an IRS perspective, if you immediately make a non-deductible contribution and then covert it to the Roth, they may go back and say that your intent was truly to do a Roth contribution, which you were ineligible to begin with. The IRS however has given no clear guidance to this, so people who use this strategy may want to wait until the following year to convert. Finally, if you own another IRA (with tax deferred dollars) and have a seperate non-deductible IRA account, you can’t just convert the non-deductibe IRA to avoid the income tax implication. The IRS looks at all the IRA’s owned and the percentage of the non-deductible IRA contributions to the value of all your IRA’s is the percentage of the conversion that will avoid taxes. This is called the cream and the coffee rule, when they are both mixed, you can’t seperate them, even if they are in seperate accounts – so it looks like this may be a bump in the road here for you.

    Paul, if you are married filing jointly and your modified adjusted gross income is below $167K, then you can contribute $6,000 each to a Roth if both of you are 50 or over ($5,000 for your wife if she is younger) or 100% of your combined earned income, whichever is less. This phases out and is no contribution is allowed if modified adjusted gross income reaches $177K. Both of you can contribute towards non-dedutible IRA’s using the same dollar limitations ($6K/$5K or 100% of earned income, whichever is less).

    Hope this helps.

  • I am >50 years old. I am contributing the max to my employer’s 401k. I have a Roth IRA in my name established several years ago, my wife has a traditional IRA established several years ago. Our joint income is over the limit to allow any deductible IRA contributions. Can I make non-deductible contributions to my Roth IRA or to my spouse’s traditional IRA? If so, what is the annual contribution limit? I understand I will need to file an IRS Form 8606 from your article. Thanks.

  • I am fully invested in my job 401 K, I make too much money so I won’t qualify for a ROTH, can I open a non-traditional IRA adding 10.000 a year (me and my wife) and convert it to ROTH right away without paying any extra taxes since I pay taxes already.
    I do have an IRA rollover (150000 $ pre-tax)from my previous job.
    Can I consider the rollover to the ROTH as coming only from the non-deductible IRA ?

  • Jeff,

    Great article

    I’m 34 and made strictly non deductable contributions to a traditional IRA in 2004 & 2005 (which I only discovered to be non-deductable when filing my taxes for 2005 – my former account did all of the tax prep). I’m embarressed to say I forogt about the IRA until now which is comprised completely of non-deducted contribution and minimal account growth. My question is can I withdraw these funds without penalties? if not what penalties would be applied?

    Not sure if my accountant submitted a 8606, will need to go back and check.

    Thanks much

  • Jeff

    Would it be fair to say that to bring down MAGI one of the ways are to contribute more to 401k at work?

    Me and my wife are very close to the income limit of $1,69,000 to be eligible to make full contribution of $5,000 to roth IRA and are looking to reduce MAGI to 1,69,000.

    Thank you very much.

  • If MAGI for Roth IRA purposes is below $167K in 2011 (married filing jointly), then the taxpayer can fully contribute to a Roth IRA subject to earned income/contribution limitations as discussed above. MAGI for Roth IRA’s are discussed here:

    http://www.fairmark.com/rothira/modagi.htm

    The web page brings up the Roth eligibility strategy of putting money towards an employer provided plan to reduce MAGI to become eligible for the Roth.

    As a disclaimer, I don’t know your full situation to make a professional determination if you are eligible for a Roth IRA contribution or not, but in what you discussed, it appears that you may potentially be eligible.

  • Jeff,

    Thank you for your response. Upon researching further I realized that me and my wife both can contribute to 401(k) and profit sharing (my wife has profit sharing at her work) approximately $15,000 each. Right now I am contributing $3,500 a year only.

    Will these contributions decrease MAGI from 1,80,000 – 15,000 (my 401k contribution) – 15,000 (my wife’s profit sharing contribution) = $150,000?

    If that is true can we both then put $5,000 each in Roth IRA?

  • AV,

    The contribution limits for 2011 are the same as a normal Traditional/Roth or combination of the both limitation. It’s the lower of $5,000 for regular contributions (an additional $1,000 if age 50 or over)or 100% of earned income (income subject to Social Security/Medicare Taxes). If your spouse earns less than these amounts, but your earned income exceeds two eligible contributions, your spouse can make what is called a spousal contribution based on your earnings.

    Contributing to a non-deductible IRA and doing this conversion annually would require that you open up a Traditional and Roth IRA, make the non-deductible contribution to the Traditional and then effect the conversion to the Roth. To make it easier, you may want to discuss with the brokerage firm if you can keep the Traditional IRA account active after the conversion (rather than close it) so you don’t have to open up a new account every year. You may want to have the Roth IRA at the same firm as well.

  • Hi Jeff,

    First of all many thanks for very clear information about back door roth IRA. My contribution to 401k is $3500 a year (including my contribution and my employer contribution). I got married this year and joint income is going to be 1,80,000 means I can not contribute to Roth IRA. I understand that I need to open a nondedctible IRA and then convert to roth IRA. I or my wife do not have regular IRA.

    My question is how much each of us can contribute to non deductible IRA per year?

    Once non deductible IRA is converted to Roth IRA how do I contributory to non deductible IRA for next year to do the same thing?

    Will appreciate you thoughts on this.

    Thank you

  • Jim, if you aren’t planning to have any earned income in 2011, then you can’t contribute to an IRA, thus no form 8606 involved here. I would contact the financial institution, explain this to them and they should be able to take care of this (re-distributing the funds back to you). The earnings on the account attributable to the extra contribution would need to be pulled out as well and would be taxable as ordinary income (which wouldn’t be a lot and subject to a 10% penalty if you are under age 59 1/2). The distribution wouldn’t be taxable as ordinary income as you haven’t filed your taxes yet for 2011. Finally, the premature withdrawal from the CD may have some penalties to that depending on the insitution. But in the end, contact the institution you hold the CD with and it should be pretty straightforward. The need of a good tax accountant may be a need as well.

  • Jeff, I retired in aug of 2010. I have a IRA cd that I set up 3 years ago which pays a yield of 4.5% and will mature july of 2013.. Tthe cd is set up to pull a 1,000 per month from my money market account at the beginning of the year for 6 months until the maximum 6,000 contribution is meet and it puts the money automatically in the ira cd that yields 4.5%. It automatically does this at the beginning of the year and will do so until the cd matures. My question is how do I take care of the 6,000 that has been put in the cd if I have no earned income for the year 2011? When I retired I was not sure if I was going to get a part time job but have not to date. Can I file a 8606 in 2011 or do I need to withdraw it from the ira cd that it is a part of now? I did not intend for this to happen and was forced into early retirement but if I don’t become employed and earn 6,000 do I have any other options? Thank you in advance jim

  • If you are fully funding your Roth’s, then you wouldn’t be able to contribute to a non-deductible IRA as you are limited in the amount that can be contributed to a Traditional/Roth as a whole.

  • My wife and I already contribute the max to our Rothschild and 401k, can we contribute to a nondeductible IRA and convert it to a Roth later?

  • I’d seek a tax specialist on this one. The problems I see here is that we are past the tax filing deadline for the year the contribution is made. Also there may be a problem with any withdrawals being required to have a pro-rata share based on the amount of deductible/non-deductible amounts made into the account. You may want to act sooner rather than later on this as if you can’t pull the funds out without some taxation, it may be worth leaving the funds in the account, but you need to file Form 8606 with the IRS to officially declare that last contribution non-dedutible so these funds won’t be taxed again upon withdrawal.

  • Hi Jeff,
    I made a contribution to my traditional IRA account this year, but found the contribution was not tax deductible because our AGI was too high last year when I filed tax.
    How can I withdraw the contribution since I don’t want it to mix with my tax deductible funds?
    Thanks so much.

  • Hi GBP,

    First off, if you are unsure of the protocol, I would hire a tax specialist to make sure that you are doing the right thing since I can’t exactly verify the problem that you have (my disclaimer). This is what I think, but you would need to confirm on your own:

    1) Recharacterizations are normally associated with Roth conversions, not a mistaken over contribution. You would have to remove the ineligible Roth contribution (and better to do it sooner than later) and pay taxes on any earnings which would be reflected in 2011 taxes. Since it is past the 2010 contribution deadline, I fear that you may not be able to change the classification of this contribution from a Roth to a non-deductible traditional IRA for 2010 now. You may want to ask your brokerage firm if you can do this. If you can’t, then you can make a 2011 non-deductible contribution (not ideal, but better than nothing). If for some reason you can change this, I don’t think you need to file an amended return (check this with a specialist) but you definitely want to file the 8606.

    2) Again, double check this with a tax specialist, but I believe that only the 8606 needs to be submitted for each year the non-deductible contribution shouldn’t affect your taxes (unless the retirement savers credit may be involved – would need to check this). I believe that there is a penalty for each year that you didn’t file this (I think it is $50 per 8606 you were supposed to file, per year you fail to produce this), but you may want to ask for an exception. In the end, the penalty may very well be better than having to pay taxes on distributions that involve after tax dollars (double taxation).

    Hope this helps.

    Jeff

  • Hi Jeff,

    Here is my situation that is related:

    I own both a Roth and a Traditional IRA. I purchased the traditional about 5-6 years ago when I was no longer eligible for the Roth due to income level. When I went to make a 2010 contribution (full $5K) I mistakenly contributed to my Roth account – this occurred a few days before contribution deadline day (around 4/14). Also, I had already filed and received a refund for my 2010 tax returns prior to the mistaken contribution. I understand that to correct this I must re-characterize the contribution with my trustee, Roth to trad IRA. While researching the procedure to do this I stumbled across these 2 questions:

    1) If I re-characterize, do I also need to refile an amended 1040 and include a 8606 (non-deductible IRA contribution) form?

    2) This next question has to do with the basis of my traditional IRA. While looking into the above, I realized I have never filed a 8606 in any prior tax year when I made non-deductible contributions to my traditional IRA (I double checked all my prior returns to ensure I had never taken a deduction) The question is then, will I need to refile ALL previous tax returns so the IRS has copies of the 8606 for all of the previous years? (Or can I just simply refile 1 time to “catch-up”)

    Thanks for your insight into this confusing matter!

  • Hi Raj

    From what you described above, this would be correct as if you have an IRA or several IRA’s, you simply can’t elect to convert your historical non-deductible contributions to the Roth. The conversion is deemed to come proportionately from the pretax and aftertax money in the account. So the smaller the amount of the non-deductible IRA contributions in proportion to the total value of the IRA, the higher that amount is taxable. You don’t have to pay tax on the funds deemed as non-deductible contributions. Recharacterization is an option as you have until October 15, 2011 to recharacterize a 2010 contribution. I highly recommend having a tax expert work with you on that as the recharacterization has to consider earnings that occured during the conversion to recharerization period as well. In the end, it may not be the worst thing in the world to keep the conversion intact if you have the cash to pay the taxes. If you have a lot of tax deferred money and a lack of tax free Roth investments, then some extra tax diversification would give you flexibility down the road in your retirement cash flow plan.

    Hope this helps.

  • Hi Jeff
    Thanks for writing this nice article.
    Here is my situation.
    I have a rollover IRA (consolidated past 401ks): 110k
    Roth IRA: 10k
    Due to income limitations we used the back door strategy to fund a Roth IRA by funding a traditional IRA for 2010 and 2011… and converting it. However my financial adivisor just called me and said we may run into tax issues b’coz of my rollover IRA and now I would now have pay taxes on the 5k I converted to Roth for this year. Is that true? Since this is after tax dollars why would I have to pay taxes again? What would be my best strategy. I am thinking of rolling back the conversion from Roth. Our AGI is greater than 160k.
    I would really appreciate your feedback.

  • Participation in a 401k doesn’t create any limitations in respect to non-deductible IRA contributions (where it does influence a potentially deductible Traditional IRA contribution).

  • Jeff, our joint income is high, so it looks like I will be making a non-deductible IRA contribution of $6,000. Wondering if the non-deductible IRA is limited by my 401k contribution in any way?

  • Hi Stan,

    The annual contribution towards an IRA (whether Roth, deductible IRA or non-deductible) is limited to $6K per year if 50 or over and $5K if under 50. So it looks like you have contributed as much as you can for the year in question.

  • Dear Jeff,
    Is there any limit as how much I can contribute to a non-deductible IRA for a given year, assuming I already contributed maximum ($6000.00)pre-tax money to my traditional (deductible)IRA and I do not have employer’s sponsored 401k available to make contributions? Thank you, Stan.

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