This article was updated on Dec. 5, 2017.
This is the funniest article you will ever read about nondeductible IRAs. I say that with a fairly high degree of confidence, given that the topic isn't exactly fertile ground for comedic exploration. (At least it hasn't been, until I typed that sentence.) Plus, I make fun of rich people later on. That's always good for a yuck or two.
So let's get this laugh riot started, and fully explore everything you need to know about nondeductible IRAs but were too sleepy to bother finding out.
Traditional IRA vs. nondeductible IRA
In many ways -- five, actually -- a nondeductible IRA is identical to a traditional IRA:
- The contribution limits for both are the same: The maximum allowable contribution for 2017 is $5,500, and if you're over the age of 50, the contribution ceiling is $6,500.
- The money you put into each type of IRA grows tax-free, meaning you don't pay any taxes on the gains your investments make or the dividends they pay you. Only once you start withdrawing the money in retirement -- or at least after age 59 1/2, when you can start taking distributions without paying early-withdrawal penalties -- do you pay taxes on your gains. At that point, you'll pay your ordinary income-tax rate during the year in which you make the withdrawal.
- In order to be eligible to contribute to either, you must have received taxable compensation (e.g. self-employment wages, salaries, fees, tips, bonuses, commissions, taxable alimony).
- Unlike the Roth IRA, there are no income limits that prevent you from being eligible to contribute the full allowable amount to either account.
- On the other hand, there is an age cutoff: Neither allows contributions to the account after you reach the age of 70 1/2, which is also the age at which Uncle Sam requires people to start making withdrawals from both types of IRAs.
So far, traditional and nondeductible IRAs seem like boring identical twins, right? But increase the microscope's magnification, and one major difference is revealed. And it's a doozie.
- With a traditional IRA, you're allowed to deduct all or part of the money you put into the account that year from your taxable income. That means you pay less in income taxes for the year. You may even find yourself bumped down to a lower overall tax bracket, which may be the only time you'll actually feel like bragging about that.
- With a nondeductible IRA, as you may have gathered by the "nondeductible" part, the IRS does not allow you to deduct your contribution from your income taxes. So there are no immediate income tax breaks for you. (Cue sad trombone music.) Yes, you'll avoid capital-gains and dividend taxes as your money grows, but you may feel some lingering bitterness about all the extra money that could have been compounding all these years had you not been denied the income-tax deduction way back when. (Or maybe that's just me.)
Of course, why the heck would anyone choose the evil twin -- or, rather, the less attractive fraternal nondeductible twin -- and pass up the immediate tax break of a traditional IRA, or even the delayed tax break of a Roth IRA?
Six reasons you'd even bother with a nondeductible IRA
In almost every scenario, a Roth IRA or traditional IRA is a better parking spot for your retirement savings than a nondeductible IRA. But those who choose the third, lesser option may not have a choice. Access to (i.e., eligibility for) other types of IRAs can be severely limited by circumstances such as these:
1. You earn a high income and have a workplace retirement plan: The deduction for a traditional IRA contribution is phased out completely -- meaning you get to deduct a big fat nothin' from your income taxes -- in 2017, if you're a single filer with a modified adjusted gross income (MAGI) of $72,000 or more. Same goes for married couples filing jointly with a MAGI of $119,000 or more.
2. You don't have a retirement plan at work, but your spouse does: That's right: Your schmoopy's retirement savings options can kick the traditional IRA deduction out of reach if you're married and filing jointly. If your combined income is above $186,000, the deductibility of your contributions gets phased out until you hit a MAGI of $196,000, at which point it completely disappears and is sucked down your gold-plated master bath toilet (unless you live in New York City, where that income barely gets you an apartment with a bathroom).
Important note: If you're rich and single, well, aren't you a catch! Besides that, if you're single and not covered by a retirement plan at work -- or if you're married and neither of you has a workplace retirement plan -- what a bummer. Workplace retirement plans are great! Anyway, your employer's stinginess does have a silver lining: None of those pesky MAGI calculations you glossed over in the previous two paragraphs apply to you. No matter how obscenely paid you are for doing whatever it is you do, you can fully deduct the maximum allowable contribution to your traditional IRA. You don't even have to give a nondeductible IRA the time of day.
3. You want to move money into a Roth IRA: For high earners who are ineligible to contribute to a Roth IRA, a little nondeductible IRA fancy footwork can get you into a Roth via the "back door" by circumventing the income limits. This is what's known as the backdoor Roth strategy, and it involves converting the nondeductible IRA into a Roth IRA -- ideally as quickly as possible -- so that you don't have to pay taxes on any gains that occur before the conversion. It can get a little complicated if you're converting an IRA that's been around for a while, or if you have a mix of nondeductible IRAs and traditional deductible IRAs.
4. You're 59 1/2 or older and want easy access to cash and tax-deferred investment growth: Even without the deductibility of your contribution, a nondeductible IRA still gives you a tax break on your investments as they grow in the account, and if you're over the age of 59-1/2, you no longer have to pay a penalty when you make withdrawals. So you have easy access to savings if you need it, and if you don't, the money that stays put continues to grow on a tax-deferred basis.
5. You want to take advantage of the full IRA contribution limit for the year, regardless of how it affects your taxes right now: Maybe you fall somewhere in the phase-out range of deductibility for a traditional IRA. That doesn't mean you can't max out your contribution. (The full allowable limit for 2017 is $5,500 if you're below the age of 50 and $6,500 if you're 50 or older.) It just means that only part of your contribution will be deductible.
Let's use your 29-year-old neighbor George to illustrate how partial deductibility works. George is single -- he's not ready to settle down just yet -- and in 2017, he was covered by a retirement plan at work. His salary is $65,000, and his MAGI comes to $68,000. George is getting serious about saving for his future and decides to make a $5,500 IRA contribution for 2017. Because he was covered by a workplace retirement plan, and his MAGI is above $67,000, he is only allowed to deduct $1,650 of his $5,500 IRA contribution. When it's time to file his 2016 taxes, George must let the IRS know that he made a nondeductible contribution to an IRA by reporting it on Form 8606.
6. You love paperwork! Not that you needed another reason to blow off even researching whether a nondeductible IRA is worthwhile for you, but this seems like as good a time as any to bring up the added administrative hassle of nondeductible IRAs:
- First, when you make contributions to your IRA, you must designate them as nondeductible by filling out Form 8606 and filing it with your tax return.
- Years later, when it's time to start shamelessly spending down your kids' inheritance, you're going to have to account for which withdrawals come from deductible contributions and earnings and which come from the nondeductible money you contributed to your account. Even if you keep the contributions in separate accounts, the IRS treats all of your traditional IRA assets as a single IRA when you start taking withdrawals. There's also something in the rules about having to follow proportionate allocation guidelines and some other stuff, the details of which are explained by the IRS in Publication 590-B -- a breezy beach read, for sure.
The final word on when to use a nondeductible IRA
As mentioned earlier, compared to a Roth IRA or traditional IRA, a nondeductible IRA is the savings option of last resort. However, if you were able to tear yourself away from this article long enough to review these Roth and traditional IRA eligibility tables, and find that you're in the non- or partial-deductibility boat, here's how a nondeductible IRA should figure into your overall retirement savings strategy.
- First, contribute enough to your workplace retirement account (e.g. 401(k), 403(b)) to get the full employer match. Then turn your attention to a Roth IRA.
- If you're eligible for a Roth IRA, this is where your next dollars should go. The Roth offers a lot of extra features unavailable with a traditional IRA. However, if you're ineligible to contribute to a Roth IRA...
- Fund a traditional IRA to get the up-front tax reduction based on your contributions. But if you find that you don't qualify for a fully deductible IRA...
- Go back to your 401(k) -- if the investment options are decent -- and fully fund it beyond the match. The 2017 401(k) contribution limits are $18,000 for those under age 50 and $24,000 for those aged 50 and over. Each of those limits increases by $500 for 2018. And lastly...
- After you've maxed out all your other retirement savings options, go with a nondeductible IRA. And don't pout about it: Remember, you still get one big tax benefit: tax-deferred compounding on your investments in the account, which means you don't pay any taxes on the growth and dividends until you start withdrawing money in retirement. At that time, you'll pay the IRS taxes on the earnings only at your current income-tax rate, because you already ponied up taxes on your contributions.
Now that you're fully fluent in nondeductible IRAs (won't your friends be impressed!), it's time for the truly fun stuff: investing your money and watching it grow. The light humor continues with our 13 Steps to Investing Foolishly. Or for the not-so-funny-but-still-important-to-know stuff about IRAs, step on over to the Fool's IRA Center, where we have all kinds of answers to your questions on IRAs.
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