There are a lot of benefits to being rich, and at least one downside: At higher incomes, the IRS excludes you from some of the biggest benefits of individual retirement accounts.
Enter the non-deductible IRA, which has more benefits than the name suggests.
What is a non-deductible IRA?
If your modified adjusted gross income (MAGI) in 2020 is greater than $ 206,000 as a married filer or greater than $ 139,000 as a single filer, you are not eligible to contribute to a Roth IRA. (These limits are respectively $ 203,000 and $ 137,000 in 2019.)
A traditional IRA technically does not have income limits for eligibility like the Roth IRA. But if you’re covered by a workplace pension plan and 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 plan of work – which you absolutely should take advantage of, especially if your employer offers matched dollars – and the non-deductible IRA.
The name gives it: a non-deductible IRA is a traditional IRA for which you don’t deduct your contributions. At first glance, it looks like any old taxable investment account. But this is not the case, for one major reason: While there is no tax benefit for making contributions, any return on investment you earn in the account will be tax-exempt until you take distributions in retirement.
When you take distributions in retirement, you will pay taxes on the investment gains, just like with a standard traditional IRA. But unlike a standard traditional IRA, the money you paid comes out tax-free because you didn’t take a deduction when you paid it.
The real benefit of a non-deductible IRA
The deferral of tax on investment income is of course an advantage. But taking that income tax-free is better – and by jumping through a few hurdles, you can achieve it with the help of a non-deductible IRA.
How? ‘Or’ What? By converting the money in a non-deductible IRA into a Roth IRA. It’s a move that you can perform with relative ease, even if you earn too much to otherwise be eligible for the Roth account. It’s called a Roth IRA backdoor, and it’s not as sinister as it sounds.
“Why not pay taxes today and live tax free in retirement?“
Joe wirbick, Certified financial planner
In fact, it’s IRS-approved and it’s something Joe Wirbick, a certified financial planner and founder of Lancaster, Pa., The Sequinox financial planning company, recommends pretty much universally. “It would be a huge mistake not to convert,” says Wirbick.
When you make contributions to a Roth, you do so with after-tax dollars. When you convert non-deductible IRA contributions to Roth, you are also converting after-tax dollars. And once this conversion is complete, any investment growth in the account can be withdrawn as a qualifying tax-free distribution.
The benefit of this cannot be overstated, especially now when taxes are low: unlike a traditional IRA, you don’t cut taxes on investment growth down the road when they are likely to be. higher. You avoid them completely.
“If you put money into a non-deductible IRA and don’t convert it, all income is tax-deferred. Why would you want to pay taxes later? Said Wirbick. “In my practice, I would say that 95% of the people I meet never retire in a lower tax bracket. So why not pay taxes today and live tax free in retirement? “
Converting a Non-Deductible IRA to a Roth IRA
The best way to convert money from a non-deductible IRA to a Roth IRA is quickly, says Wirbick. This is because a Roth IRA conversion has a tricky area: it requires paying taxes on any untaxed money before it lands in the Roth account. (It’s even more complicated if you have other IRAs as well – say from a 401 (k) rollover – because the IRS looks at all accounts combined and your conversion is prorated. Learn more , read our complete guide to Roth IRA backdoor.)
“There is no rule for how long you have to go [the money] in there, ”says Wirbick. “But if you’re lucky and the growth starts quickly, when you do the conversion you will have to pay taxes on that growth.”
It’s not a big deal, but it makes it easier to do your entire year’s contribution all at once and then convert that amount. (The maximum IRA contribution in 2020 is $ 6,000, or $ 7,000 if you’re 50 or older; the limits were the same in 2019.) You can usually leave the non-deductible IRA open if you want to start over. this maneuver next year, but check to make sure your account provider doesn’t require a minimum balance.
Most brokerage firms will help you with the conversion and will earn you any taxes you owe. But you should still keep track of all earnings and contributions on your own, and consult a tax advisor to make sure you have declared non-deductible contributions and made the conversion correctly.
Finally, know that this is a decision you cannot take back – tax reform laws have eliminated the ability of people to reverse a conversion.