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 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?
If your modified adjusted gross income (MAGI) in 2019 is more than $203,000 as a married tax filer or more than $137,000 as a single filer, you’re not eligible to contribute to a Roth IRA. (Contributions for the 2018 tax year are not allowed if your MAGI is more than $199,000 if you’re married and $135,000 for single filers.)
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.
That leaves you with that workplace plan — which you should absolutely take advantage of, especially if your employer offers matching dollars — and the 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.
At that point, you’ll pay taxes on investment gains just like with a standard traditional IRA. But unlike a standard account, the money you contributed comes out without taxes, because you didn’t take a deduction when you put it in.
The real benefit of a nondeductible IRA
Tax-deferral of investment earnings is a perk, sure. But taking those earnings tax-free is better — and by jumping through a few hoops, you can achieve that with the help of a nondeductible IRA.
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.
Why not pay taxes today and live tax-free in retirement?
In fact, it’s IRS-approved and something Joe Wirbick, a certified financial planner and founder of Lancaster, Pennsylvania, financial planning firm Sequinox, pretty much universally recommends. “It would be a huge mistake not to convert,” Wirbick says.
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.
“If you put money into a nondeductible IRA and you don’t convert it, all the earnings are tax-deferred. Why would you want to pay taxes later?” Wirbick says. “In my practice, I would say 95% of the people I meet never retire to a lower tax bracket. So why not pay taxes today and live tax-free in retirement?”
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, Wirbick says. 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.)
“There’s no rule for how long you have to leave [the money] in there,” Wirbick explains. “But if you get lucky and it starts growing rapidly, when you do the conversion you’ll have to pay taxes on that growth.”
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 maximum IRA contribution in 2019 is $6,000, or $7,000 if you’re 50 or older, up from $5,500 and $6,500 in 2018.) You can typically leave the nondeductible IRA open if you want to pull this maneuver again next year, though check to ensure your account provider doesn’t require a minimum balance.
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.
Finally, know that this is a move you can’t take back — tax reform laws eliminated people’s ability to reverse a conversion. But Wirbick thinks it’s unlikely you’ll want to.
After the $1.5 trillion tax cut, he says, “Taxes are on sale. Take advantage.”