Qualified retirement accounts are a great way to invest for your retirement. In all cases, the money you invest in those types of plans can grow tax-deferred while it is in the plan. In addition, in some cases, you get a deduction for contributing to the plan while in others, you can take qualifying withdrawals completely tax free in retirement.
In one type of plan, however, the non-deductible Traditional IRA, you get neither a tax deduction for contributing nor the ability to take tax free qualifying withdrawals. To make matters worse, when you withdraw money from that type of plan, your gains are taxed as ordinary income, removing the benefits of long-term capital gains tax rates in standard brokerage accounts. That raises a key question: Why invest in a non-deductible Traditional IRA at all?
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A backdoor way to the Roth IRA
One key reason people still contribute to non-deductible Traditional IRAs is the fact that they can use that contribution as the first step of what is known as a Backdoor Roth IRA. If you contribute money to a Traditional IRA and then shortly thereafter convert it to a Roth IRA, you can get the money in a Roth IRA. That "backdoor" approach lets you get money into a Roth IRA account if your income is too high to directly contribute to a Roth .
The challenge, though, is that if you have other money already in Traditional IRAs, the total tax impact of contributing then converting may be too high for it to be worth that quick conversion. This is because your total Traditional IRA balance and basis is used to determine how taxable a Roth conversion is , and that interaction can end up raising your total tax bill. Still, if turning it into a backdoor Roth IRA doesn't make sense, you still might want to contribute to a non-deductible Traditional IRA for other reasons.
Keep it for later Roth conversions when your income is down
Another reason people contribute to non-deductible Traditional IRAs is to have the money in a format where they can convert it to a Roth IRA later, when their income is down. After all, the two ways to get money into a Roth IRA are to directly contribute it from earned income or to convert it from other qualified retirement accounts.
If you're expecting a period of low income, it could be a good time to convert the money in your account to a Roth IRA. For instance, if you anticipate retiring before Social Security or required minimum distributions from your retirement accounts kick in, you could have low overall income for a few years. That can give you an opportunity for Roth IRA conversions with a relatively low tax cost.
Keep your money from burning a hole in your pocket
In addition, people who recognize they'll spend every dollar that "sticks around" too long might take advantage of a non-deductible Traditional IRA for the benefits from the penalty for early withdrawal. In most cases, if you take money out of an IRA early, you pay a 10% penalty on top of any taxes you owe on it . That extra penalty can serve as a deterrent from spending the money, allowing it to grow and compound until retirement.
The reality is that if you ultimately keep nothing invested for your retirement, you'll end up with nothing when you do retire. If that 10% extra penalty is enough of a deterrent to keep you from tapping your retirement early, then having money in that type of account certainly beats not having it at all.
Keep more of your money in your own pocket
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On the flip side, having money in a non-deductible Traditional IRA can also help you keep more of your money in your pocket when others come looking for it. For instance, college financial aid formulas generally don't include assets inside IRAs when considering families' expected contribution amounts . That can help you keep your money working for your retirement instead of going toward your children's educations.
Similarly, your IRAs have better creditor protection than ordinary investment accounts do . As a result, if you're worried about being forced into bankruptcy from lawsuits or medical bills, having a non-deductible Traditional IRA can give you a better chance of keeping something for yourself.
If you want one, now is the time to put your plans in motion
Although many people saving for their retirements will prefer other retirement account types to the non-deductible Traditional IRA, they can still serve a useful purpose in your overall financial plan. If you're considering investing in one, your time is limited. You need enough earned income within the year to cover your contribution, and there's a limit to the amount you can sock away each year.
For 2020, the contribution limit is $6,000 if you're under age 50 or $7,000 if you're aged 50 or up. You can make contributions to your non-deductible Traditional IRA for 2020 until April 15, 2021 . As a result, you still have some time to scrape up the cash to put into your account for this year. Once the window is shut, however, it's shut. So if you'd like to take advantage of it, now is a great time to start planning for it. Get started now, and you can still put your non-deductible Traditional IRA to use for you for 2020.
