You just got a raise at work and paid off all your debt. Now you can’t wait to start a new IRA in addition to maxing out your 401K. Sadly you quickly learn that you don’t meet the requirements to deduct your IRA contributions and you make too much to open a Roth IRA.
So what to do? How can you still save for retirement and get the benefits of an IRA?
A little know fact on IRA’s; you can contribute to them no matter how much you make. You just can’t deduct the amount that you put in there on your tax return. These are called Non-deductible IRA’s.
How Non-Deductible IRA’s Works:
You contribute to a traditional IRA and then at tax time you file Form 8606 with the IRS so they know that you are not taking a deduction. This form allows you to not pay taxes on that portion of your assets when you go to take money out. It establishes a cost basis for your account.
You do not need to tell your investing company that it is non-deductible as it is a regular IRA but with different tax considerations, only you, your CPA and the IRS need to know it is non-deductible. Other than the tax considerations nothing else is different from a traditional IRA!
Is it Right for You: Benefits of a Non – Deductible IRA?
Using a non deductible allows you to get the benefit of tax deferred growth on your investments. Taxes, like fees, have a big impact on your total money available at retirement. Tax deferred growth allows you to not pay taxes on any of your earnings until you take them out of the account. Thus you have more every year to grow your asset base. It is a great place for assets that are not tax efficient such as bonds, REIT’s and other high payout investments.
You would do a non-deductible if you are over the income limit for opening a ROTH, you have maxed out any 401K’s you have access to and you don’t qualify for deductions on a Traditional IRA.
Cautions
Unfortunately doing a non-deductible is not completely as straight forward as it would seem because of the tax issues that go with it when you do actually take the money out of the account. I am not actually going to get too much into the tax issues as they are bound to change from year to year and each and every person is different. (You can get more info here) I am however going to go over some of the highlights that you need to keep in mind.
- Because of the tax treatment of IRA’s doing a non-deductible it does take a bit of organizing and record keeping. So if you constantly lose papers, don’t file your taxes correctly or have no clue which funds you have then don’t even consider having a non-deductible IRA unless you have an amazing CPA! Lack of good paperwork means you pay more taxes in the end and the goal of this is to pay less in taxes. First learn to organize your paperwork.
- All Traditional IRA’s in your name are considered one IRA by the IRS even if they have different investments at different brokerages. Because of this you cannot separate your deductible portion from your non-deductible portion. Therefore if you roll or begin taking distributions you need to allocate taxes based on the percentage of non-deductible.
- When you do take money out it is currently taxed at ordinary income levels instead of capital gains rates. So depending on the assets you have in the account will determine if the tax deferral option is beneficial to you.
- You are still subject to early withdrawal penalties on the non-deductible, so hands off till you are 59 ½!
What I Do and Why:
I know this seems like a lot of rules and a lot of what if’s, in fact it makes you want to just go ahead and use taxable accounts. I on the other hand prefer to use the non-deductible for a few reasons.
- I am very organized with my money so already do the bookkeeping necessary for this investment.
- Tax rates and rules change, so how that money gets treated when I retire may be completely different from today.
- There are options for getting this money into a Roth IRA. (You can convert, but that too has tax issues you need to consider).
- You only get once chance to put money into retirement accounts; you can’t go back and put in your IRA contribution for 10 years ago. So I would rather have the money in the accounts so I can latter use them for tax and estate planning.
- I like to have money in many types of retirement and non-retirement accounts so that when retirement does come I have options for withdrawals, tax plans and estate planning.
This can be a great way to get extra funds into retirement accounts. Talk with your CPA about the benefits using a non-deductible IRA for your investing and tax planning. Then get to investing!
