High earners such as physicians often focus on pre-tax contribution and may overlook some of the advantages in contributing to a nondeductible IRA account.
The basic premise of contributions made into a traditional IRA is that those contributions are pre-tax dollars, meaning the investor will pay taxes when the funds are withdrawn from the account at a later date. On the other hand, Roth IRA accounts are funded with post-tax money; the taxes on those funds are paid upfront so that when the account owner makes qualified withdrawals, they will not have to pay taxes at that time.
But one can make nondeductible contributions into a traditional IRA account. These are basically post-tax dollars being used to fund a traditional IRA, and they are not deducted on the account owner’s tax return. Since the taxes have already been paid, those contributions are not taxed upon distribution, unlike usual pre-tax traditional IRA contributions.
The nondeductible contributions made into a traditional IRA have the same limits as pre-tax monies. For 2020 and 2021, the contribution limit is $6000, or $7000 if the investor is age 50 or older as a catchup contribution amount. While an account owner can make both nondeductible and deductible contributions to their IRA, it generally makes sense to keep separate accounts for each type. Blending the two types of contributions can make tax requirements more confusing to track, as the pre-tax money contributed to the account is still taxable upon distribution, and the amount of nondeductible contribution, or basis, must be reported on tax returns using Form 8606.
So, what is the benefit of a nondeductible IRA?
This type of account may be a good choice for high-income earners, as those investors are often locked out of Roth IRAs by their income level. For 2021, the maximum income amount for a single investor is set at $140,000 — an individual earning more than this cannot open a Roth IRA, and even for those earning more than $125,000, their ability to contribute has a phase-out schedule. For a high-income earner, utilizing a nondeductible IRA as a saving method may be a strategy to put into place in preparation for opening a “backdoor Roth IRA.”
What is a backdoor Roth IRA?
A “backdoor Roth IRA” is a method that involves making IRA contributions and then converting the account to a Roth IRA. In this way, those who cannot open a Roth IRA due to their high-income level still have access to the benefits offered by Roth IRA accounts, including not paying taxes on distributions and tax-free growth within the account.
As a Roth IRA is funded with post-tax dollars, when opening a backdoor Roth IRA, the taxes must be paid on any pre-tax dollars that were used to fund the traditional IRA. For ease of conversion, nondeductible contributions can be made annually to a traditional IRA and then immediately converted.
It must be remembered that taxes are not calculated by only taking into consideration those specific funds that are being converted. The investor will pay taxes on any amount above the basis calculated using the pro-rata formula, where the IRS will look at the amounts of all the investor’s IRA accounts together. In this, the percentage of the nondeductible is considered the base. However, the remaining percentage is considered taxable income for the year of the conversion.
To avoid this difficulty, there is the option of moving traditional IRA monies to a qualified employer plan, such as a 401(k), as these amounts are not included in the calculation that the IRS makes for the Roth IRA conversion. After the funds have been transferred, a new traditional IRA can be opened and funded with nondeductible contributions, and then that amount can be converted to a new Roth IRA. In this way, the base is the only money taken into account, and the taxes have already been paid before the funds were even contributed to the new traditional IRA.
When utilizing a nondeductible IRA, there are some mistakes to avoid. One of the most common mistakes is forgetting to file properly to account for the nondeductible contributions. The amount must be reported using Form 8606 with a tax return. Should an investor neglect to report the basis, this can be done after the fact.
Another mistake is assuming that only nondeductible amounts can be converted to a Roth IRA. As the IRS takes into consideration all IRA accounts when determining owed tax, any of that money can be converted to a Roth IRA, pre-or post-tax contributions alike. As shown above, there are methods of avoiding a larger tax liability at that time.
The tax ramifications of that decision should be discussed with a financial professional, as should any aspect of using a nondeductible IRA as a strategy, as the application can be complex and should be undertaken only with a full understanding of how the strategy fits into an individual’s financial planning goals.
Securities are offered through Securities America, Inc., member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. Wall Street Alliance Group and Securities America are separate companies. You should continue to rely on confirmations and statements received from the custodian(s) of your assets. Securities America and its representatives do not provide tax or legal advice; therefore, it is important to coordinate with your tax or legal advisor regarding your specific situation.
Syed Nishat is a partner, Wall Street Alliance Group. He can be reached on LinkedIn and on Twitter @syedmnishat. He holds the FINRA Series 7, FINRA Series 63, and FINRA Series 66 licenses, along with licenses for life, disability, and long-term care insurance.
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