Here are 3 reasons why you should consider contributing to a non-deductible IRA.
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Mike Bernard, CFP® offers advisory services through KFG Wealth Management, LLC dba Korhorn Financial Group. This information is for general financial education and is not intended to provide specific investment advice or recommendations. All investing and investment strategies involve risk including the potential loss of principal. Asset allocation & diversification do not ensure a profit or prevent a loss in a declining market. Past performance is not a guarantee of future results….(read more)
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Should You Contribute To a Non-Deductible IRA?
When it comes to saving for retirement, an Individual retirement account (IRA) is a popular choice among many investors. With its tax advantages and potential for growth, it’s no wonder why people consider contributing to an IRA. However, there are different types of IRAs, and one that often raises questions is the non-deductible IRA. Should you contribute to a non-deductible IRA? Let’s explore its benefits and drawbacks to help you make an informed decision.
What is a non-deductible IRA?
A non-deductible IRA is an individual retirement account that allows you to contribute after-tax dollars, meaning you cannot deduct these contributions on your tax return. Unlike a traditional IRA, where your contributions are tax-deductible, the non-deductible IRA offers no upfront tax benefits. Nevertheless, any earnings generated within the account grow tax-deferred.
Benefits of a non-deductible IRA
● Tax-deferred growth: Although you don’t receive an immediate tax benefit, the advantage of a non-deductible IRA lies in its ability to grow tax-deferred. This means that any capital gains, dividends, or interest accumulated within the account will not be taxed until you withdraw them in retirement. It allows your investments to compound and potentially grow faster over time.
● Backdoor Roth conversion: One of the main advantages of contributing to a non-deductible IRA is its potential for conversion into a Roth IRA through a backdoor conversion. As of 2021, there are income limitations for contributing directly to a Roth IRA. However, a non-deductible IRA can be converted to a Roth IRA regardless of your income. This conversion allows you to enjoy the tax-free growth and withdrawals that a Roth IRA offers.
Drawbacks of a non-deductible IRA
● No upfront tax benefit: Unlike a traditional IRA, where contributions are tax-deductible, a non-deductible IRA offers no immediate tax benefit. This reduces the immediate tax savings and may be a factor to consider for individuals seeking to lower their taxable income.
● Pro-rata rule: When converting a non-deductible IRA to a Roth IRA, it’s important to consider the pro-rata rule. If you have existing pre-tax dollars in any traditional IRA, the conversion will trigger a tax liability on a proportional basis. For example, if you have $100,000 in pre-tax funds in a traditional IRA and convert a $5,000 non-deductible IRA into a Roth IRA, 95% of the conversion will be subject to taxes. This can make the backdoor Roth conversion less beneficial for those with existing traditional IRA balances.
● Contribution limits: Similar to other IRAs, non-deductible IRAs have contribution limits. As of 2021, the maximum annual contribution for individuals under 50 is $6,000, and for individuals 50 and older, it is $7,000. If you are already maximizing your contributions to other retirement accounts, such as a 401(k) or a traditional or Roth IRA, you may not have additional funds available to contribute to a non-deductible IRA.
Conclusion
Deciding whether to contribute to a non-deductible IRA depends on your individual circumstances and financial goals. If you are ineligible for a traditional IRA due to income limitations and still want to save for retirement in a tax-advantaged account, a non-deductible IRA can provide tax-deferred growth and the opportunity for a backdoor Roth conversion. However, it’s essential to weigh the lack of upfront tax benefits, the pro-rata rule, and the contribution limits before making your decision. Consulting with a financial advisor can help you navigate the complexities of retirement savings and determine the best course of action for your specific situation.
I think sometimes people focus to much on the raw data. Retirement is an art as well. Sure it makes more financial sense to contribute after tax $$ to brokerage acct rather than traditional IRA. However for many ppl you need that account that you CANT touch. Having a regular taxable account and you get laid off or kid needs braces or family emergency. It’s soo easy to dig into that brokerage acct. Having a traditional IRA you can’t touch until 59 1/2.
Thanks for this video, this is exactly what I was looking for! You explained the backdoor IRA vs Non-Deductible IRA trade offs and tax implications eloquently.
Dont you want to..
a) 401k – get company match
b) HSA – max out
c) Roth IRA – max out
d) 401k – try to max out from there?
Well this was somewhat confusing. I have been contributing to a non-deduct IRA for over 10 years now and just resigned myself to paying tax on any distributions above my basis until I watched this. If I understand this video correctly, I can move the entire non-deduct IRA to my 401(k) and then move the basis (basically my non-deduct contributions) to a Roth and then at retirement move my 401(k) to a new IRA. This strategy would yield no tax consequences. I fail to understand what is actually gained since when I take distributions out of the non-deduct existing IRA only a portion in excess of my contributions is taxed. Do I have the strategy correct (move to 401(k) and then to a Roth for the basis) and what is gained by doing this versus just leaving it in a non-deduct IRA. Thank you.
Absolutely people should contribute to a Traditional IRA to plan for conversion to ROTH IRA in future years
So a non deductible IRA can roll into a 401k then out into a Roth IRA without tax consequences or just the basis can roll out into a Roth IRA without tax consequences and any gain into a traditional IRA?