Should You Make Non-Deductible IRA Contributions?

If you find yourself in the position of having too high of an income to make a deductible contribution to your IRA for the year ($110,000 for joint filers in 2011, $66,000 for Single and Head of Household), you may be wondering if it’s a good idea to make a non-deductible contribution to your IRA.

There are two opposing camps on this issue, and the deciding factor is how you’re intending to use the funds in the near term.

When It’s a Good Idea

If you’re intending to convert your IRA to a Roth and your income is too high to just make the contribution directly to the Roth account, the non-deductible IRA may be the right choice for you.  This way you’re effectively working around the income limitations of the Roth contribution ($179,000 for joint filers in 2011 or $122,000 for single or head of household filers).

You also have more funds available in your IRA account, which provides you with the ability to take advantage of economies of scale – certain mutual funds have higher minimum purchase amounts, for example.  Since the money is in an IRA you don’t have to track holding periods, non-qualified dividends versus qualified dividends, and your paperwork is reduced.

In addition, depending upon your state laws your money may be protected against creditors since it’s part of an IRA.

When It’s a Bad Idea

If you’re not planning to convert this IRA to Roth, you’re effectively increasing the tax cost of your investment gains (under today’s law).  Since withdrawals of investment gains from your IRA are taxed at ordinary income tax rates (up to 35% under today’s rates), you’re effectively giving yourself a tax increase over the capital gains rate which is 15% at the maximum these days.

Instead of making a non-deductible contribution to your IRA, you could just make your investment in a taxable account.  Then within this account you could make investments geared toward long-term gains rather than income or dividends, therefore deferring tax until you sell the investment.  And when you do sell the investment it will be taxed at the currently much lower capital gains rate versus the ordinary income tax rate (which would be applied if you made your contribution in the IRA).

Conclusion

So – depending on what you’re planning to do with the account, a non-deductible contribution could be a good idea or a bad idea.  You will have to make that call.  Hopefully the information above will help you with your decision.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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12 Comments

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  • Thomas,

    You could make the non-deductible contributions to a traditional IRA, but since you have other traditional IRA money, presumably some of this is either deductible contributions, rollovers, or growth of the funds (or a combination of the three). With this in mind, you would not be able to convert your non-deductible contributions separately to Roth IRAs tax-free, since distributions from your IRAs are taxed or untaxed pro rata.

    That doesn’t mean that non-deductible contributions are a terrible idea, but you could probably have a lower tax treatment for the growth of your investments if you just put that money in a taxable account. In addition, if you don’t intend to access the money at all, such as by investing in an index fund and just letting it grow over your lifetime, at your passing your heirs would receive a step-up in value to the current value of the investments, effectively erasing all tax impact. This assumes that today’s laws remain in effect.

    Hope this helps –

    jb

  • my wife and I have both a Trad Ira and Roth IRA. Our income prevents us from making a deductable contribution to to the Roth which we would prefer, would it benefit us to make a non-deductible contribution to our Trad IRA’s?

  • John,

    Unfortunately no. You would owe tax on the gain in the account upon a conversion. Plus, if you have any other IRA accounts with deferred gains or deducted contributions, you have to apply taxability and non-taxability in a pro-rata fashion across all accounts as you do your conversion.

    In other words, if you had three other IRAs that had deductible contributions in them (plus growth over the years) and all of your IRAs totaled together were $80,000, when you take $10,000 out to convert to a Roth IRA, only 10% of the conversion amount, $1,000, would be non-taxed on the conversion. This is because your non-deductible contributions were $8,000 (10%) out of the total $80,000.

    Hope this helps –

    Oh, by the way – the option to make non-deductible contributions to an IRA wasn’t only available during the 1990’s, it’s still available today.

    jb

  • Jim–

    in the 90’s (pre-Roth IRA) there were 2-3 years in which, if you could not take a IRA deduction, you could make still non-deductible contributions to an IRA. I did this and the $8,000 I contributed is now worth $20,000. Can I convert the $20,000 to a Roth IRA and not pay tax on the conversion gain of $12,000?

    John

  • David,

    It sounds like a non-deductible traditional IRA contribution could be useful for you, and you could convert that IRA sometime later to a Roth IRA (at least under present law).

    This is a very limited amount of money though, $6,000 per year since you’re over age 50, so the usefulness is somewhat limited. But, as mentioned, at least under present law it’s allowed so you might as well take advantage of it.

    jb

  • Jim,

    Presently I am 52 years old and have a total portfolio investment in traditional IRAs and Roths of approximately $300k and an additonal taxable investments of $375k. I am considering changing investment options to reduce the volatility in my portfolio. I do not qualify for the deductible IRA or Roth. Is a non-deductible Roth a good option for conversion of the taxable investments over time. I have no present need for the funds and they would not be touched until retirement.

    Thanks, David

  • Laurie –

    Unfortunately, traditional IRA contributions are not allowed once a taxpayer reaches age 70. If he’s still working, he may be able to make non-deductible contributions to a 401(k) or other employer plan and convert those to Roth at a later date.

    jb

  • Jim,

    do you know if there is a way for a 73 yearold whom is still working to contribute to a Non-deductible IRA and then convert these funds to his Roth IRA? Or since he is 73 he cannot utilize the Non-deductible IRA in order to get funds into his Roth IRA? His wages are too high to contribute directly into his Roth IRA. Laurie

  • What do you mean in your answer above “as long as that option remains available”. Is there any situation that you can not contribute to a non-deductible IRA and then convert to a Roth IRA? Thanks

  • AV-

    If your income is too high to make regular contributions to the Roth account, your only option is the non-deductible IRA/conversion route, as long as that option remains available.

    I’d also max out your 401(k) contributions, and if you have more capacity to save, begin saving in a taxable account as well. Diversifying your tax treatment of savings is a good idea, as you never know what will happen with future treatment of your 401(k) and Roth accounts.

    Hope this helps –

    jb

  • Hi Jim,

    I am 27 years old and just got married. I started to contribute to my employer based 401k in October 2010. Yearly contribution would be around $3500. I got married recently and realized that joint income of 180,000 would not allow us to make roth IRA contribution which we missed out when both of us were single.

    Rightnow neither of us have an IRA.

    What would be the best strategy for us as a couple?

    As we are late starters we would not mind making some big contributions in coming few years to make it up.

    If we open non deductible IRA and convert that to roth IRA can we again contribute next year or have to open another non deductible IRA and convert again?

    Thank you very much

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