Nondeductible IRAs: The 1 Time They Really Make Sense

Most people use IRAs because of the tax breaks they offer. However, if you make too much money and have access to an employer-sponsored retirement plan at work, then it's possible that your only IRA option will be a nondeductible traditional IRA. That's far from ideal, but there are a few reasons why a nondeductible IRA can be better than nothing when it comes to your retirement savings. Below, we'll look at why you might have to use a nondeductible IRA and how it can be useful.

If you're looking for a path to a Roth IRA but can't contribute directly because of income limits, a nondeductible IRA might give you a special opportunity. Image source: Getty Images.

When nondeductible IRAs are your only option

Most people who are saving for retirement prefer to avoid nondeductible IRAs. The most popular type of IRA is the deductible traditional IRA. If you qualify, then you can deduct your contributions to a traditional IRA and get an immediate tax benefit. Moreover, because this tax break is available until the April tax filing deadline, you can still make a contribution toward an IRA for the 2016 tax year even though 2017 has already begun, and those who are eligible can deduct those contributions on their 2016 tax returns.

On the other hand, some people prefer to use Roth IRAs. A Roth won't give you an upfront tax deduction, but what it will do is give you the ability to withdraw money in retirement on a tax-free basis. As long as you follow the rules for Roth IRAs, any income or gains from the after-tax money you contribute will escape tax entirely, and that can be a huge benefit to those who expect to be in a high tax bracket after they retire.

The problem, though, is that some taxpayers can't use either of these two types of IRAs because their income is too high. Those who earn above certain income limits aren't allowed to contribute to a Roth IRA at all. Different income limits apply to traditional IRAs for those who either have an employer-sponsored retirement plan at work or whose spouse has such a plan, and although they don't prevent you from contributing, they do take away the deduction for traditional IRA contributions.

Why nondeductible IRAs can be helpful

So if your income is too high, your only IRA choice will be a nondeductible IRA. Many people don't bother with nondeductible IRAs, and in some cases, that's not a bad move. Because the most common reason you can't deduct your IRA contribution is that you have access to a 401(k) or other employer plan at work, then the obvious solution is to contribute more money to that 401(k) plan account. Many people find the high limits on 401(k) plans -- $18,000 for those who are younger than 50, or $24,000 for those who are 50 or older -- to be more than sufficient for their needs.

However, there's still one situation where it truly makes sense to use a nondeductible IRA. It involves a strategy that's known as the backdoor Roth, and it works really well if you've never been able to contribute to a regular deductible IRA.

The basics of the backdoor Roth

Here's how the backdoor Roth works: First, you contribute money to a nondeductible IRA. Then, you take that nondeductible IRA and convert it into a Roth IRA. The conversion is allowed because past income limits that prevented Roth conversions have been repealed, and so you can convert a traditional IRA to a Roth IRA regardless of how much money you make.

Ordinarily, when you convert a traditional IRA to a Roth, you have to pay tax on the amount that you convert. However, for a nondeductible IRA, you don't have to pay tax on the contribution that you made. The reasoning is that because you didn't get a tax deduction for it when you contributed the money, you shouldn't have to pay tax on it when you convert.

From a practical standpoint, you might end up having a very small taxable element to your Roth conversion. It's usually smart to let a short period of time go by between contributing to the nondeductible IRA and doing the Roth conversion. If your assets generate income during that time, then the profit will be subject to tax. However, the vast bulk of your nondeductible IRA assets won't get taxed, and the end result will be almost exactly the same as if you had been allowed to contribute to a Roth in the first place.

Finally, things get complicated if you have both deductible and nondeductible IRAs. Even if you only convert the nondeductible IRA, the IRS requires you to treat the conversion as coming equally from all your IRA assets. So if you contribute $5,000 to a nondeductible IRA and have $15,000 in regular deductible IRA assets, then when you convert the $5,000, only one-quarter of that amount, or $1,250, will be treated as coming from the nondeductible portion. The remaining $3,750 will be treated as coming from the deductible IRA, and you'll have to pay tax on it. That's why the backdoor Roth strategy works best when you don't have other IRAs.

Take a look at nondeductible IRAs

Nondeductible IRAs are in some ways the worst of both worlds, and that can make them less than ideal. However, they're worth a look if you have no other choice, especially if the backdoor Roth option is something you can use.