What Is a Nondeductible IRA?
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There’s plenty of upside to being wealthy, and at least one downside: At higher incomes, the IRS shuts you out of some of the biggest tax benefits of individual retirement accounts.
Specifically, if you earn too much to contribute to a Roth IRA, there's a good chance you're also ineligible to deduct contributions to a traditional IRA. Enter the nondeductible IRA, which has more advantages than the name implies.
What is a nondeductible IRA?
The name gives it away: A nondeductible IRA is a traditional IRA for which you don’t deduct your contributions. On the surface, that makes it sound like any old taxable investment account. But it isn’t, for one big reason: While there’s no tax benefit for making contributions, any investment returns you earn in the account will be tax-deferred until you take distributions in retirement.
When you take distributions in retirement, you’ll pay taxes on investment gains just like with a standard traditional IRA. But unlike a standard traditional IRA, the money you contributed comes out without taxes, because you didn’t take a deduction when you put it in.
When you can't deduct contributions to an IRA
A traditional IRA doesn’t technically have income limits for eligibility like the Roth IRA. But if you’re covered by a retirement plan at work and you earn too much to contribute to a Roth IRA, you also earn too much to deduct your contributions to a traditional IRA.
In 2023, if you are a single filer and you are covered by a retirement plan at work, you're no longer eligible to deduct contributions to a traditional IRA at incomes of $83,000 or more. If you're married filing jointly and you have a retirement plan at work, that income threshold is $136,000 or more. (If you don't have a retirement plan but your spouse does, you can deduct IRA contributions until your income hits $228,000.)
» See the full IRA income limits here
If you're not eligible to deduct traditional IRA contributions, your options for retirement accounts narrow significantly. You're left with that workplace plan — which you should absolutely take advantage of, especially if your employer offers matching dollars — and the nondeductible IRA.
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The real benefit of a nondeductible IRA
The tax-deferral of investment earnings you get from a nondeductible IRA is a perk, sure. But making those earnings tax-free is better — and by jumping through a few hoops, you can achieve that.
How? By converting the money in a nondeductible IRA to a Roth IRA. This is a move you can execute with relative ease, even if you earn too much to be otherwise eligible for the Roth account. It’s called a backdoor Roth IRA, and it’s not nearly as sinister as it sounds.
In fact, it’s IRS-approved and something financial advisors frequently recommend for higher-income folks.
When you make contributions to a Roth, you do it with after-tax dollars. When you convert nondeductible IRA contributions to a Roth, you’re converting after-tax dollars, too. And once that conversion is complete, any investment growth within the account can be pulled out as a qualified distribution tax-free.
The benefit of that can’t be overstated, particularly now when taxes are low: Unlike a traditional IRA, you’re not kicking taxes on investment growth down the road, when they are likely to be higher. You’re avoiding them completely.
Converting a nondeductible IRA into a Roth IRA
The best way to convert the money in a nondeductible IRA into a Roth IRA is quickly. That’s because a Roth IRA conversion does have a tricky area: It requires paying taxes on any untaxed money before it lands in the Roth account. (This is even trickier if you also have other IRAs — say from a 401(k) rollover — because the IRS looks at all accounts combined and your conversion is taxed pro-rata. For more on that, read our full guide to backdoor Roth IRAs.)
Even if you don't have other IRAs, if you allow the contributions you make to your traditional IRA to earn an investment return, you may have to pay taxes on that growth when you do the conversion.
That’s not a huge issue, but it does simplify things to make your entire year’s contribution at once and then convert that amount. The IRA contribution limit is $6,500 in 2023 ($7,500 if age 50 and older).
Most brokerages will help you with the conversion, and report to you any tax you’ll owe. But you should still keep track of any gains and contributions on your own, and consult with a tax advisor to ensure you’ve reported nondeductible contributions and completed the conversion correctly.
» Take it one step further: Read our guide to mega backdoor Roths
Finally, know that this is a move you can’t take back — tax reform laws eliminated the ability to reverse a conversion.