An IRA is one of the most popular tools available to help individuals save for retirement. But depending on your annual income, you may not be eligible for some of the tax advantages these accounts offer. That’s where a non-deductible IRA comes in.
A non-deductible IRA isn’t actually a type of retirement account. Instead, it refers to non-deductible contributions that you make to a traditional retirement account. It’s a type of retirement savings strategy available to those whose income exceeds the limits to make deductible IRA contributions or to contribute to a Roth IRA.
Wondering whether a non-deductible IRA is right for you? Keep reading to learn how a non-deductible IRA works, who they are for, and what you need to know about using one.
How a Non-Deductible IRA Works
An individual retirement account (IRA) is a tax-advantaged account that allows you to either deduct your contributions (traditional) or withdraw money tax-free during retirement (Roth). But there are some restrictions around who can enjoy the tax benefits of most IRAs.
The term non-deductible IRA refers to traditional IRA contributions you make that aren’t eligible for the tax advantages of a traditional IRA. Even if you don’t qualify for deductible IRA contributions, you can still make contributions to the account. Your account will still grow tax-deferred, meaning the account still provides some shelter from taxes throughout your working years. Then, once you begin taking distributions during retirement, you’ll pay income taxes on the growth of that money.
How a Non-Deductible IRA Differs From Other Retirement Accounts
The primary difference between a non-deductible IRA and other types of IRAs is that you don’t get some of the tax advantages. To clarify, let’s discuss the tax advantages of the two most popular types of IRAs — traditional and Roth — compared to those of a non-deductible IRA.
When you contribute to a traditional IRA, you’re able to claim a tax deduction for your contributions. As a result, you can reduce your taxable income for tax-year 2021 by up to $6,000, or potentially up to $7,000 if you are 50 or older and eligible for catch up contributions of $1,000. Then, the money in the account grows tax-deferred until you pay income taxes on it when you take distributions.
In the case of a Roth IRA, the tax advantage comes at a different time from the traditional IRA. When you contribute to a Roth IRA, you can’t claim a tax deduction. Instead, the money in the account grows tax-free, and then you can withdraw it tax-free during retirement.
When you contribute to a non-deductible IRA, you can’t claim a tax deduction. The only real tax advantage is that your money grows tax-deferred in the account. As a result, you won’t have to worry about paying taxes while it grows.
If you are making non-deductible IRA contributions, it likely means you don’t meet the eligibility requirements of either a traditional or Roth IRA.
Whether or not you can make deductible contributions to a traditional IRA depends on a few factors. You must:
- Fall below the threshold for modified adjusted gross income (MAGI)
- Have earned income (wages or self employment income)
If you are covered by a workplace retirement plan, you must fall within the income limits below to make deductible traditional IRA contributions in the tax-year 2021:
|Filing Status||Modified Adjusted Gross Income (MAGI)||Deduction|
head of household
|$66,000 or less||full deduction|
|$66,000 – $76,000||partial deduction|
|$76,000 or more||no deduction|
|married filing jointly or qualifying widow(er)||$105,000 or less||full deduction|
|$105,000 – $125,000||partial deduction|
|$125,000 or more||no deduction|
|married filing separately||less than $10,000||partial deduction|
|$10,000 or more||no deduction|
If you aren’t covered by a workplace retirement plan, you may be able to deduct your entire traditional IRA contribution, regardless of your income. But your deductible amount also depends on whether you have a spouse who is covered by a retirement plan at work. If you aren’t covered by a workplace retirement plan, you must fall within the income limits below to make deductible traditional IRA contributions:
|Filing Status||Modified Adjusted Gross Income (MAGI)||Deduction|
|single, head of household, or qualifying widow(er)||any amount||full deduction|
|married filing jointly or separately with a spouse who is not covered by a plan at work||any amount||full deduction|
|married filing jointly with a spouse who is covered by a plan at work||$198,000 or less||full deduction|
|$198,000 – $208,000||partial deduction|
|$208,000 or more||no deduction|
|married filing separately with a spouse who is covered by a plan at work||less than $10,000||partial deduction|
|$10,000 or more||no deduction|
Anyone can contribute to a traditional IRA, even if they don’t meet the requirements to take a tax deduction for their contributions. But the same can’t be said about a Roth IRA. You’ll have to meet the IRS requirements for this type of retirement account to even contribute.
If you’re single, head of household, or married and filing separately with a spouse you don’t live with, then you may contribute to a Roth IRA if you earn less than or equal to $125,000. If your income exceeds $125,000, then you can only contribute a reduced amount. But once your income reaches $140,000, then you can’t contribute at all.
For married folks filing jointly, the income cap is $198,000 to contribute the full amount. Allowed contributions are reduced until they phase out entirely when your joint income exceeds $208,000.
Non-Deductible IRA Rules
As with other retirement accounts, there are a handful of rules you’ll have to follow to ensure you’re using the non-deductible IRA correctly. The key things to know include the filing requirements, contribution limits, and distribution rules.
The IRS requires that anyone who makes non-deductible IRA contributions files Form 8606 with their annual tax return each year. The purpose of this form is to document your after-tax contribution. If you fail to complete it, then you may be subject to additional taxes later on.
The IRS limits the amount that someone can contribute to an IRA each year. In 2021, the contribution limit for both deductible and non-deductible IRA contributions is $6,000. It increases to $7,000 for those age 50 or older.
It’s important to note that to contribute to an IRA you must have earned income, and your IRA contributions can’t exceed your earned income for the year. Since non-deductible IRA contributions are primarily used by those whose income is too high to allow them to take advantage of deductible or Roth IRA contributions, this likely won’t be a concern.
When you take distributions from your non-deductible IRA, you’ll have to pay taxes on your earnings. But the good news is that because you’ve already paid taxes on your contributions, you won’t be taxed again for them.
Unfortunately, when you withdraw money from your IRA, you can’t choose whether to take taxable or non-taxable distributions. Instead, each distribution will be split proportional to the percentage of contributions vs. earnings in the account. So if your account is 75% non-deductible contributions and 25% taxable earnings, then 25% of your distribution will be taxable.
You can begin taking penalty-free distributions from your non-deductible IRA at age 59½. If you withdraw earlier, you’ll pay a 10% penalty on your distributions unless you qualify for an exception. The IRS also requires that you begin taking required minimum distributions (RMDs) once you reach age 72. RMDs don’t apply to Roth IRAs, but they do apply to both deductible and non-deductible IRA contributions.
What to Consider Before Using a Non-Deductible IRA
One of the greatest advantages of contribution to IRAs is that you can either reduce your taxable income in the year that you make a contribution, or you can reduce your tax burden during retirement. Unfortunately, a non-deductible IRA doesn’t come with those same advantages. As a result, it’s not as powerful of a tool for reducing your tax burden while saving for retirement.
That being said, let’s not write off the non-deductible IRA altogether. There are still some advantages worth talking about.
First, a non-deductible IRA is still a way of setting aside money for retirement and investing it for growth. And considering only about half of American families had any sort of retirement account at all as of 2019, according to the Federal Reserve, we can agree that saving for retirement at all is an important step.
It’s also important to remember that just because the non-deductible IRA doesn’t have as many tax advantages as deductible or Roth IRA contributions doesn’t mean there aren’t any advantages. As we’ve discussed, the money in a non-deductible IRA still grows tax-deferred. As a result, you’re still reducing your tax burden during your working years. After all, if those investments were in a taxable brokerage account, you might be subject to taxes on your capital gains, interest income, dividends, etc.
Finally, there are other steps you can take to ensure that non-deductible IRA contributions are the last resort so that you can fully take advantage of any tax breaks available to you. Here are a few steps you can take before you make non-deductible IRA contributions:
- Learn your IRA contribution eligibility: In most cases, someone makes non-deductible IRA contributions because they aren’t eligible to make deductible or Roth contributions. But even if you don’t think you’re eligible or haven’t been eligible in the past, it’s worth double-checking just to make sure you aren’t leaving tax breaks on the table.
- Max out your workplace retirement account: If your workplace offers a retirement plan like a 401(k) plan, then focus your contributions there before turning to a non-deductible IRA. Contributions to a 401(k) are deductible no matter your income. If you’re already maxing out your contributions, then you can choose to contribute to both a 401(k) and an IRA.
- Consider a self-employed retirement plan: If you’re self-employed, then consider one of the many retirement savings vehicles available to you there, including a SEP IRA, SIMPLE IRA, or Solo 401(k). Contributions to those accounts are tax-deductible.
Non-Deductible IRAs and Backdoor Roth Conversions
For those that have already contributed to a non-deductible IRA or plan to do so in the future, there’s one key tool that you can use to gain some serious tax advantages. That tool, known as the backdoor Roth IRA, allows you to convert the money in your traditional retirement account into a Roth IRA.
Unlike normal Roth IRA contributions, which are only available to those who fall under a certain income, a Roth conversion is available to anyone, regardless of their tax bracket. And once the money is in a Roth IRA, it will grow tax-free, and you won’t pay taxes on the money during retirement.
The advantage of a non-deductible IRA to Roth IRA conversion is that you aren’t subject to the biggest downside of most Roth IRA conversions: the taxes. When someone converts deductible contributions from a traditional IRA to a Roth IRA, they must pay income taxes on that money. For someone with a large IRA balance, the taxes could be significant. But because you’ve already paid taxes on your non-deductible IRA contributions, there’s no tax burden to converting the money to a Roth.
Remember though that you can’t choose whether to take out deductible or non-deductible contributions; you have to take them out in proportion to one another. This means that if your IRA has both deductible and non-deductible contributions, converting to a Roth may come with a tax burden. We recommend talking to your financial advisor about the details before taking action.
The Bottom Line
Many people love IRAs for the tax advantages they offer, allowing you to reduce your tax burden either in the years you make contributions or during retirement. Unfortunately, IRS income limits prevent certain taxpayers from enjoying the full tax benefits of a deductible traditional IRA or a Roth IRA.
While the non-deductible IRA may not be as powerful as its deductible and Roth alternatives, it’s still a way of enjoying some tax advantages while boosting your retirement nest egg. And you may even be able to use a Roth conversion to convert your non-deductible IRA contributions into a tax-advantaged account to enjoy tax-free distributions during retirement.
Remember that non-deductible IRA contributions require additional tax forms, and a Roth conversion can be a bit complex. If you’re using this type of account, you may want to enlist the help of a financial or tax expert to help.
Preparing for retirement is part of your overall financial plan. You can take a few actions now to get yourself on the right track.
- Download 65 Ways to Retire Smart, an actionable guide with insights from fiduciary financial advisors. The guide is free.
- Sign up for the Personal Capital Dashboard. Millions of people use these free and secure online financial tools to see all of their accounts in one place and plan for long-term goals, like saving for retirement.
- Consider talking to a fiduciary financial advisor for more detailed guidance on your retirement saving strategies.