Let’s say you wish to contribute to an IRA in 2018, but have too much income to make a either a deductible contribution to a traditional IRA or a contribution to a Roth IRA.
You still have the option to make a nondeductible contribution to a traditional IRA. Might this make sense for you?
There are two basic, but quite different, reasons to make nondeductible contributions to a traditional IRA.
1) To obtain tax deferral for investments. Investment returns on the contributed funds will compound tax deferred as long as they stay in the IRA. This is most beneficial when the IRA invests in assets that produce income normally taxed at high ordinary rates (i.e. corporate bonds, distributions from real estate investment trusts, short-term gains from active stock trading).
This is advantageous, compared to investing in a taxable account, but on to the downside…
- Distributions will be taxed at ordinary rates. If the account earns long-term capital gains, the favorable tax rate for them will be lost when distributed from the IRA. If the IRA owner dies, assets in the IRA will not receive stepped-up basis and gains will remain taxable when distributed to the IRA beneficiary.
- Extra recordkeeping is required. Nondeductible contributions in an IRA are tax-free when distributed. To be able to separate them from taxable distributions of investment returns, the IRA owner must record them by filing IRS form 8606 and keeping these forms for the life of the IRA. The IRA owner is responsible for this. You can’t rely on the IRA custodian to do it, or on getting back records from the IRS.
2) To make a “back door” contribution to a Roth IRA. Having too much income to contribute directly to a Roth IRA doesn’t stop you from contributing indirectly. The tax law places no income limits on eligibility to make nondeductible contributions to a traditional IRA or to convert a traditional IRA to a Roth IRA.
Thus, no matter how high one’s income, one can make a nondeductible contribution of up to $5,500 to a traditional IRA in 2018 ($6,500 if age 50 or older) and then convert it to a Roth IRA, effectively making a Roth IRA contribution.
Be aware that making nondeductible contributions for either purpose may result in an unexpected tax bill.
The Potential Tax Surprise
Say you have a traditional IRA with only a recently made nondeductible contribution in it — no earnings, and you decide to take a distribution of its full balance. You may assume the distribution will be income tax free, because it consists entirely of nondeductible funds.
But this might not be so. If you own any other traditional IRAs, the distribution might be almost entirely taxable. This is because the IRS aggregates all your traditional IRAs, treats them as one, and treats distributions as if they come from the combined balance.
Example: You have $5,000 in a traditional IRA just set up to make a “back door” Roth conversion. All the money is from a nondeductible contribution. If you have no other IRA, the conversion will be tax free.
…But say instead that you own another traditional IRA holding $120,000 consisting entirely of deducted contributions and earnings. The IRS aggregates the balance of your two IRAs — $125,000. The nondeductible contribution of $5,000 is just 4% of that. Thus, any distribution from either of the two IRAs will be deemed to be 96% taxable income and only a 4% tax-free return of nondeductible contributions.
The $5,000 Roth IRA conversion will result in $4,800 of taxable income. Likewise, a $5,000 distribution from either IRA taken to spend will result in the same taxable amount.
Note that the tax-free distribution of the $5,000 of nondeductible contributions isn’t lost. Realize that it is just delayed to take place proportionately as the entire IRA is distributed — requiring long-term recordkeeping.
Nondeductible contributions to a traditional IRA can pay off, if used carefully for the right purposes. However, they can also increase the complexity of record keeping and tax calculations. Before making one, check with your financial advisor to see if it will fit your situation.