5 Tips on Nondeductible IRAs and Taxable Accounts

Laura covers five tips for choosing the best types of retirement accounts for you and your family. Having more than one account is awesome, but the rules to qualify can be a little tricky. 

Laura Adams, MBA
8-minute read
Episode #571

4. Use a nondeductible IRA as a last resort.

If you’re like Marta and have income that’s too high to qualify for a Roth IRA or for a fully deductible traditional IRA (because you also have a workplace plan), consider a nondeductible IRA your last resort for a tax break.

A nondeductible IRA is simply a traditional IRA funded with after-tax dollars. However, even though you don’t get an immediate tax benefit for contributions, your earnings in a nondeductible IRA are still tax-deferred. In other words, as your non-deductible balance grows, you avoid tax on gains and dividends until you take withdrawals in retirement.

Here’s an important tip: Instead of mixing deductible and non-deductible contributions in the same IRA, open another IRA to keep the two types of contributions separate. Also, be aware that if you make non-deductible contributions you must submit IRS Form 8606 when you file taxes.

Having this recordkeeping is one downside to a nondeductible IRA. It’s your responsibility to keep up with the amount of deductible versus nondeductible 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!

Another confusing aspect of a nondeductible IRA is that the IRS treats all of your traditional IRA assets as a single IRA when you start taking withdrawals. It’s a bit complicated, but when you have both deductible and nondeductible contributions (even in separate accounts) only a portion of your investment gains in the account may be tax-free.  

5. Consider converting a nondeductible IRA to a Roth.

To sum up, it’s always better to contribute to a Roth IRA or a traditional IRA when you can. But if you contribute to a nondeductible IRA, another option is to convert it to a Roth IRA, known as a “backdoor Roth IRA.” This is a way for high earners, who are ineligible to contribute to a Roth IRA, to still have one using a workaround strategy.

Once a year you can make a nondeductible IRA contribution and then convert it to a Roth IRA. When you do a Roth conversion, you must pay tax on any amount that wasn’t previously taxed.

Note that a Roth conversion can be a bit complicated if you’ve had your IRA for a while or you have a mix of nondeductible and deductible IRAs. So be sure to contact your IRA custodian or provider for conversion instructions. Also, as I previously mentioned, don’t forget to submit IRS Form 8606 with your tax return any time you make nondeductible contributions to an IRA.

Free Resource: Retirement Account Comparison Chart (PDF download) - get the rules for the most popular retirement accounts

Should You Contribute to a Nondeductible IRA or a Taxable Account?

The major benefit of making contributions to a nondeductible IRA is that you defer taxation on growth in the account. That’s a nice benefit because you get to skip paying tax on earnings in the account until you withdraw them.

The remaining investment vehicle that anyone with any amount of income or any retirement account can use is a regular, taxable brokerage account. You must pay capital gains tax rates that can be as high as 20% for investments owned more than a year.

In contrast, you pay ordinary income tax rates on withdrawals from retirement accounts. The 2018 income tax brackets range from 10% up to 37%, depending on how much you earn.

Whether you’d pay more or less tax using a nondeductible IRA or a brokerage account really depends on a variety of factors, such as what investments you own, how long you own them, and how much you earn.

So, I can’t give you a definitive answer about whether you’ll come out ahead with a nondeductible IRA or a brokerage account. The best way to know is to consult with a tax or financial planner about the pros and cons of contributing to a nondeductible IRA when you also have a retirement plan at work.

Also, as I mentioned, the recordkeeping for a non-deductible IRA can be tricky. 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 nondeductible IRA territory. The downside is that you could wind up paying more in taxes, instead of less.

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About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.