Investing in a Nondeductible IRA

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  • If you exceed the income limits for tax-deductible IRA or Roth IRA contributions, a nondeductible IRA is another tax-advantaged way to save for retirement.

When you're planning for retirement, individual retirement accounts (IRA) offer tax-advantaged ways to invest money. When you don't qualify for a traditional IRA, a nondeductible IRA is another way to save. Before you open one, it's important to understand how these accounts work and how they affect your taxes now and in the future.

What Is a Nondeductible IRA?

A nondeductible IRA is an individual retirement account that you fund with after-tax dollars. That means you can't deduct the contributions from your taxable income. However, your money grows tax-free, and you won't pay taxes on withdrawals until you take out the gains.

Imagine you invest $60,000 in a nondeductible IRA over the course of 10 years. When you retire, it's worth $69,000. You won't pay tax when you withdraw the first $60,000. When you withdraw the last $9,000 — your gains — it will be taxed as income.

Do Nondeductible IRAs Have Contribution Limits?

The IRS limits the amount of money you can contribute to your IRAs each year; this includes all types of IRAs, including nondeductible IRAs. In 2022, you can contribute up to $6,000 across all your IRAs. If you're 50 or older, you may be eligible for a $1,000 catch-up contribution, bringing the total to $7,000 per year.

For traditional and Roth IRAs, your contribution limits are affected by your income and retirement plan availability. At a certain income level, you're no longer allowed to make contributions to these accounts.

Nondeductible IRAs aren't subject to these income restrictions. You can contribute the maximum each year, regardless of your income, retirement plan and filing status.

Reporting and Designating Nondeductible IRA Contributions

When you open a nondeductible IRA, you won't need to specify a special type of IRA — it's simply a traditional IRA funded with nondeductible contributions. You don't need to designate contributions as nondeductible when you make them; instead, you do so at tax time using IRS Form 8606.

It's critical to report your nondeductible contributions. If you don't, the IRS won't have a record proving that you've already paid taxes on the money, and withdrawals may be taxed as income. In other words, you'll be taxed twice.

Withdrawal Rules for a Nondeductible IRA

Nondeductible IRAs are subject to similar withdrawal rules as traditional IRAs. That means as long as you're at least 59.5 years old, you can take out money without paying penalties. If you withdraw the money before that, you'll pay a 10% penalty.

Deciding Whether To Contribute to a Nondeductible IRA

A nondeductible IRA has significant disadvantages in comparison to traditional and Roth IRAs. Unlike traditional IRAs, you can't deduct contributions, and unlike Roth IRAs, you'll need to pay taxes when you withdraw gains.

Given these drawbacks, why would you choose a nondeductible IRA? To start, your money will still grow tax-free, which gives it an advantage over many other investment options.

It's common to open a nondeductible IRA when you don't qualify for a traditional or Roth IRA. This can happen in the following situations:

  • Traditional IRA with retirement plan: If your employer offers a retirement plan, you're filing single or head of household and your modified adjusted gross income (MAGI) is $78,000 or more in 2022, you can't make tax-deductible contributions to a traditional IRA. The same applies if you're married and filing jointly and your MAGI is $129,000 or more.
  • Traditional IRA without/partially without retirement plan: If you don't have a retirement plan, you can't make tax-deductible contributions if you're married and filing jointly, your spouse is covered by a retirement plan and your MAGI is $214,000 or more in 2022. You also can't make tax-deductible contributions if you're married and filing separately, your spouse has a retirement plan and your MAGI is $10,000 or more.
  • Roth IRA: In 2022, if you're married and filing jointly with a MAGI of $214,000 or more, you can't contribute to a Roth IRA. You're also prohibited from contributing if you're filing single or as the head of household and your MAGI is $144,0000 or more.

Converting a Nondeductible IRA to a Roth IRA

If your income prevents you from opening a Roth IRA, you'll lose out on a number of benefits. As long as you've reached age 59.5 or older and your oldest IRA is at least 5 years old, you don't pay taxes when you withdraw your gains from a Roth IRA. Plus, there are no withdrawal deadlines or required distributions, and you can pass the account to your heirs tax-free. That gives it a big advantage over a nondeductible IRA.

Fortunately, there's a solution — you can convert a nondeductible IRA into a Roth IRA. This process is often referred to as creating a "backdoor" Roth IRA. It's a legal way to open a Roth IRA, even if you exceed standard income limits.

You can complete the conversion without penalties using three methods:

  • Rollover: After you withdraw funds from your nondeductible IRA, you have 60 days to put them in a Roth IRA.
  • Trustee to trustee: This happens when your nondeductible IRA administrator transfers the money directly to the administrator of the Roth IRA. 
  • Same trustee: If you're opening a Roth IRA with the same institution that administers your nondeductible IRA, they'll simply move it between accounts.

When you're ready to make the conversion, speak to the administrator of your nondeductible IRA. They'll walk you through the process and provide all the necessary paperwork. You'll also need to open a Roth IRA. Once the paperwork is complete, you'll move part or all of the funds from the nondeductible IRA into the new Roth IRA.

Tax on Backdoor IRAs

Before you jump into a backdoor IRA, make sure to consider the potential tax implications. If you don't have any other traditional or Roth IRAs, the process is simple. Because you've already paid taxes on the contributions, you won't need to pay taxes on the rollover.

If you do have other IRAs, things get more complicated. In this situation, the IRS assesses taxes based on something called the "pro rata rule." They'll start by looking at the funds in all your IRAs, including
SEP IRAs. The ratio of deductible to nondeductible contributions across all accounts will determine what percentage of your rollover funds are taxed.

How does the pro rata rule work in practice? If your IRAs consist of 90% nondeductible and 10% deductible contributions, 10% of the rollover funds will be taxed as income. If your total IRA contributions are 60% nondeductible and 40% deductible, you'll pay income tax on 40% of the rollover funds.

Is a Backdoor IRA the Right Choice for You?

Converting a nondeductible IRA can be an easy way for high-earners to get the benefits of a Roth IRA. If your only IRAs are funded with nondeductible contributions, there's usually no reason not to proceed. If you have other IRAs, it's important to consult with a tax professional; they can help you determine if you'll benefit from the conversion.


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