Should You Contribute to a Non-Deductible IRA?
Find out if making non-deductible IRA contributions is right for you. Plus, other investment options if you’ve maxed out your workplace 401(k).
I recently received a couple of related questions about making contributions to multiple retirement accounts. Marta says:
“I max out my 401(k) at work each year and still have more to invest. If I contribute to a traditional IRA I understand that I don’t get a tax deduction. But I can’t contribute to a Roth IRA because I earn too much. What should I do?”
“I maxed out my 401(k) for 2012 and want to know if I can also max out an IRA. If so, would my IRA contributions also be tax-deductible?”
Both of these questions beg for an explanation of the rules and whether using a non-deductible IRA is right for you.
What Is the Difference Between Deductible and Non-Deductible?
First, let’s cover the terms deductible and non-deductible. Certain expenses—like mortgage interest, charitable donations, and qualified retirement contributions—allow you to legally reduce your taxes because, in general, they can be deducted from your taxable income.
It’s always smart to reduce your taxable income because that cuts the amount of tax you have to pay so you get to keep more of your hard-earned money. So, a tax-deductible expense is one that has the potential to reduce your taxable income and save money—but a non-deductible expense does not.
What Retirement Accounts Are Tax-Deductible?
The distinction between deductible and non-deductible is important when it comes to retirement accounts. Here’s what you need to know:
With a traditional retirement account, you make contributions on a pre-tax basis, meaning before taxes are taken out. Or you can claim a deduction on your tax return, which essentially gives you a refund for taxes you previously paid during the year.
The rule is that you don’t have to pay any tax on contributions or earnings in a traditional retirement account until you make withdrawals at some time in the future.
However, whether you qualify for a deductible IRA depends on whether you (or a spouse) participate in a retirement plan at work, your tax filing status, and your income. If you don’t qualify for a deductible IRA, you can contribute to a non-deductible traditional IRA (I’ll give you more details about that in a moment).
With a Roth retirement account, your contributions are always non-deductible because you must fund it on an after-tax basis. In other words, you have to pay tax upfront on Roth contributions and never get to claim them as a deduction on your tax return.
But unlike a traditional retirement account, withdrawals you make from a Roth IRA during retirement are completely tax free. You get to skip paying tax on decades of growth in the account, which can add up to massive savings.
What Are the Roth IRA Income Limits?
But the rub with Roth IRAs is that high earners are excluded from making contributions, which is what Marta mentioned is her situation.
For 2013, if you’re married and file taxes jointly, you can’t make Roth IRA contributions if your modified adjusted gross income (MAGI) tops $188,000. If you don’t file jointly, you can’t make Roth IRA contributions when your MAGI exceeds $127,000.
What Are the Retirement Account Contribution Limits?
Both Marta and Arthur are in enviable positions because they’re maxing out their 401(k)s. That means they contributed $17,000 in 2012 or are on pace to put in $17,500 for 2013, in addition to any amounts their employers contribute. Plus, if you’re over 50 you can sock away an additional $5,500 each year.
But what happens when you max out a retirement plan at work and still have more to invest? The good news is that you can also max out an IRA; however, the contribution limits for IRAs are much lower than for workplace plans.
For 2012, you can put $5,000 in either a traditional IRA, a Roth IRA, or a combination of both. For 2013, the limit is bumped up to $5,500. And if you’re 50 or older, you can contribute an additional $500 to an IRA each year.
So, I’d recommend that Arthur max out a Roth IRA if he’s eligible. As I mentioned, Roth IRA contributions are not tax-deductible, which means there’s never a conflict with participating in a retirement plan at work and a Roth IRA in the same year.
To learn more, read or listen to the episode called Your Guide to the Roth IRA, Part 1.
What Is a Non-Deductible IRA?
But let’s say you participate in a retirement plan at work and make too much for the Roth IRA, like Marta. She can still max out a traditional IRA. However, some or all of her contributions may not be tax deductible.
You don’t get the full deduction if you file taxes jointly and have MAGI over $95,000. Or if you don’t file jointly, your MAGI generally can’t exceed $59,000.
Additionally, if you make contributions to a traditional IRA that are not deductible, you’re required to file IRS Form 8606, Nondeductible IRAs. If this sounds complicated, it’s because it is!
It’s your responsibility to keep up with the amount of deductible versus non-deductible contributions in your traditional IRA. Otherwise, you and the IRS won’t know whether you owe tax on future withdrawals from the account and you could end up paying tax twice!
Should You Contribute to a Non-Deductible IRA?
The major benefit of making contributions to a non-deductible IRA is that you defer taxation on growth in the account. That’s a nice benefit for investments that pay regular dividends, like bonds. You get to skip paying tax on earnings in the account until you withdraw them.
However, the recordkeeping for a non-deductible IRA can be a nightmare. So if you’re not extremely organized, don’t have a great tax accountant, or don’t know the exact investments you have in your IRA, I don’t recommend entering into non-deductible IRA territory. The downside is that you could wind up paying more in taxes, instead of less.
So be sure to consult with a tax or financial planner about the pros and cons of contributing to a traditional IRA when you also have a retirement plan at work. Or play it safe and invest in a Roth IRA if you’re eligible or stick with a taxable brokerage account.
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