If your income is over the limit for deductible and Roth IRA contributions, you are faced with a dilemma each year: should you contribute to a non-deductible IRA? Making a non-deductible contribution shouldn’t be an automatic decision. It could be beneficial, or investing the same amount of money in a taxable account could be a superior choice.
Like most decisions in personal finance, there’s not one right answer for everyone.
Non-Deductible IRA contribution benefits:
- Your earnings grow on a tax-deferred basis. This means that you can reinvest all of your dividends and capital gains without paying taxes on them as you go. You are also free to buy, sell, and rebalance investments in your account without tracking each investment’s cost basis, gain, or loss for income tax purposes.
- There’s a psychological benefit to putting money in a retirement account for many people – you may be less likely to tap into the funds if you know there would be penalties.
- Non-deductible contributions create Roth conversion opportunities with less tax owed than if the entire conversion were pre-tax.
Non-deductible IRA contribution drawbacks:
- Your earnings when withdrawn will be taxed at regular income tax rates rather than capital gains tax rates. Right now capital gains rates are 15% for those in the 25% and higher tax brackets and are scheduled to go to 20% next year. So if you’re instead paying 35% or higher income tax on the withdrawals, that’s a big hit.
- Loss of flexibility – if you withdrawal the funds before 59 ½, you will be subject to penalties unless you qualify for an exception.
So how do you decide if it makes sense for you?
First – Consider what your tax bracket is pre-retirement and what it will likely be in retirement.
To do this, you or your financial planner will need to consider your likely sources of income in retirement and their tax status. You also need to make some assumptions about future tax rates — of course no one has a crystal ball, so an educated guess is the best you can do with this aspect.
- If you think your tax bracket will be the same, higher, or just slightly lower in retirement, then non-deductible contributions are likely not a good move for you (unless one of the other benefits applies).
- If your tax bracket will be a lot lower in retirement – like moving from 28% to 15%, then non-deductible contributions should definitely be considered.
After you’ve answered the first question, then you should consider possible Roth IRA conversion opportunities. If you don’t have other assets in traditional or roll-over IRAs, you can make non-deductible contributions and convert them to Roth IRAs with only taxes owed on the growth between contribution and conversion. This can be a very beneficial technique to get assets into a Roth IRA even when your income exceeds the Roth contribution limits. There are very specific rules for conversions, so it’s important to consult with your financial or tax advisor to make sure you follow them correctly.
Lastly, if your decision still isn’t clear, consider the loss of flexibility. Depending on your money personality, this can be a positive or a negative. The positive is less temptation to tap into retirement funds early. The negative is the penalties for doing so. You need to know yourself and know whether the loss of flexibility is good or bad for your situation.
Bottom line, don’t put your non-deductible IRA contribution on auto-pilot. It’s important to do the analysis because your decision can affect how quickly your assets grow and how much income you have in retirement.