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not as exciting as a deductible IRA, earnings from the non-deductible IRA remain sheltered from income taxes until withdrawn.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.
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.