What is a nondeductible IRA? It’s often not easy to decide what kind of IRA account might best suit you, because there are different kinds to choose from. Understanding how accounts differ and ways each type can affect your savings is an important part of knowing which kind to open. For example, how is a nondeductible IRA different from a deductible IRA? How about a nondeductible IRA vs Roth IRA? Below are some facts you can consider to help you figure out if a nondeductible IRA is the right choice for you.
What Is A Nondeductible IRA? | All You Need To Know
In this article:
- What is a Nondeductible IRA?
- Why Consider a Nondeductible IRA?
- How about Roth IRA vs Nondeductible IRA?
- Nondeductible IRA vs. Taxable Account
- What Is a Backdoor Roth Conversion?
- What Is the IRS Form 8606?
What is a Nondeductible IRA?
There are many similarities between different types of IRA accounts, such as the deductible IRA and the nondeductible IRA. There are also differences that make each standout, such as tax benefits. As the name suggests, a nondeductible IRA does not allow you to deduct your contributions from your yearly taxes. A deductible IRA is just the opposite — your yearly contributions can be deducted from your taxes at the end of the year, essentially giving you back the taxes you paid on money earned earlier that year.
Why Consider a Nondeductible IRA?
If you can’t deduct your contributions from your income taxes, why consider getting this type of IRA? Well, there are in fact benefits to think about with a nondeductible IRA.
One of the benefits comes when your income is too high to get tax benefits with a Traditional IRA. In this case, the nondeductible makes more sense. The limits on tax benefits are based on modified adjusted gross income. If you are single and have a modified adjusted gross income of $72,000 or are married filing jointly with an income of $119,000, you may benefit more from a nondeductible IRA. You won’t have to worry about nondeductible IRA income limits.
If you are married and your combined income is over $186,000, the nondeductible IRA may offer the most benefit if you don’t have a retirement savings plan but your spouse does.
If you don’t qualify for a Roth IRA because of your income level, getting a nondeductible IRA gives you a chance to make contributions to an IRA when you would be otherwise unable.
How about Roth IRA vs Nondeductible IRA?
You might notice that a nondeductible IRA sounds an awful lot like a Roth IRA, but they are different. With both types, you make contributions and the money is not deducted from your income taxes. In other words, you pay the taxes the same year you make the contributions. The difference between the two is once again related to your taxes.
With a Roth IRA, the investment income you make from the account is tax-free. If you contribute $80,000 over your lifetime and you get a distribution of $900,000 when you retire, you don’t pay taxes on any of it.
With a nondeductible IRA, you pay taxes on your investment savings. If you end up with $900,000 dollars when you retire, you pay taxes on $820,000 of it. The benefit here is that you don’t pay taxes on your money at the time of contribution.
Nondeductible IRA vs. Taxable Account
When you use a nondeductible IRA to save for retirement, your distributions are taxed as income. That’s different than investing your money in a taxable account, which has you pay at the capital gains rate once it comes time to pay comes time to pay taxes on your investment income.
What Is a Backdoor Roth Conversion?
If your income is too high for your to qualify for a Roth IRA, the nondeductible account can get you in the back door. You open and contribute to a nondeductible IRA and then convert it to a Roth down the road. There will still be some tax issues with this plan, though. However, it’s a good way to take advantage of at least some of the tax benefits that come with a Roth IRA.
What Is the IRS Form 8606?
If you choose not to convert your nondeductible IRA to a Roth, it’s important to be aware of the risks. If you contribute to both a deductible and a nondeductible IRA, keep careful track of your contributions over the years. That’s tricky if you spend 50 years putting money into the various types of IRA. If you don’t keep track of these contributions, you could end up paying more in taxes than is necessary and it will be hard to get that money back even if you know what’s happened.
That’s where the IRS form 8606 comes into play. This is a yearly and optional form you can file with the IRS that specifies how much you make in after-tax IRA contributions like the ones that go into a nondeductible IRA. The money you put into a traditional IRA is pre-tax, so you don’t pay taxes on it. The contributions to the nondeductible account are post-tax and you pay on them each year as part of your income tax.
The other thing worth considering is what tax bracket you will be in once you start taking distributions from your IRA. For most people, their tax bracket drops in retirement because they are not working any longer, which means no regular paychecks. If your tax bracket is higher, though, you will pay more. That’s true whether you open a traditional or nondeductible IRA.
If you already have a nondeductible IRA but want to convert it to a Roth IRA, watch this video from Alan Moore.
Still don’t know what kind of IRA to open? For most people, the Traditional or Roth is a great choice. However, it’s a good rule of thumb to understand all of your options, including nondeductible IRAs.
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