5 Tips on Nondeductible IRAs and Taxable Accounts
Laura covers five tips for choosing the best types of retirement accounts for you and your family. Having more than one account is awesome, but the rules to qualify can be a little tricky.
In last week’s post, 6 Ways the New Tax Rules Affect Your Retirement, I covered the updated IRS regulations for retirement accounts, such as workplace plans and IRAs in 2019. I received several questions from readers about how to choose the best account.
Harish says, “I don’t qualify for the tax benefits of an IRA because of my income. Is there any advantage in investing in an IRA with no tax benefits instead of using a regular brokerage account?”
Marta says, “I max out my 401(k) at work every year and still have more to invest. If I contribute to a traditional IRA I understand that I don’t get a tax deduction. But I can’t contribute to a Roth IRA because I earn too much. What should I do?”
Arthur asks, “I maxed out my 401(k) for the year and want to know if I can also max out an IRA. If so, would my IRA contributions also be tax-deductible?”
In this post, I’ll explain what to do when faced with the choice of a nondeductible IRA or a taxable brokerage account. You’ll learn five tips for choosing the best types of retirement accounts for you and your family.
Nondeductible IRA or Taxable Account? 5 Tips to Know Which Is Best
- Max out a retirement plan at work first.
- Use a traditional IRA when it’s fully deductible.
- Use a Roth IRA when you qualify.
- Use a non-deductible IRA as a last resort.
- Consider converting a non-deductible IRA to a Roth.
The best retirement account(s) for you vary based on what’s offered at your job or a spouse’s job, whether you’re self-employed, how much you earn, and your tax filing status. Review each of these tips for a guide to choosing the right vehicles to fund and grow your retirement nest egg.
1. Max out a retirement plan at work first.
If you have any type of retirement plan offered by an employer, such as a 401(k), 403(b), 457, or TSP, it should always be your go-to savings account. Not only can you contribute more than you can with an IRA, but your employer may also contribute additional, free matching funds.
The 2019 workplace retirement account limits are increasing to $19,000, or $25,000 if you’re over age 50. IRAs are great, but the contribution limits are only up to $6,000, or $7,000 if you’re over age 50.
So always opt to max out a workplace plan when you can. Once you’ve contributed the annual retirement limit at work, then it’s time to turn your attention to other options, such as a traditional or a Roth IRA.
Once you’ve contributed the annual retirement limit at work, then it’s time to turn your attention to other options, such as a traditional or a Roth IRA.
Also note that if you have a Roth account at work, you’re eligible no matter how much you earn. Unlike a Roth IRA, which comes with annual income limits, a Roth 401(k) or a Roth 403(b) doesn’t have any income requirements. The main benefit of a Roth is that you pay tax upfront on contributions, but can take withdrawals in retirement that are completely tax-free.
A common question is what to do if your employer doesn’t offer matching. Even if your employer is stingy, I’m still a proponent of maxing out a workplace retirement plan. These accounts offer too many benefits to ignore, including:
- Convenient automatic payroll deductions
- Broad federal legal protections under the Employee Retirement Income Security Act of 1974 (ERISA)
- Guidance from your employer or the plan’s administrator
So don’t pout if there aren’t any matching funds and keep saving as much as you can. If you max out a retirement account at work and still have more to invest, bravo!
Keep reading to understand the choices you should make next. And if you don’t have a job with a retirement plan, these tips will also help you choose the best account for your situation.
2. Use a traditional IRA when it’s fully deductible.
A traditional IRA is a great choice when you need an upfront tax break. Your contributions may be tax-deductible, even if you don’t itemize deductions on your tax return. Plus, a traditional IRA has no income limit, which makes it a smart choice when you’re a high earner who doesn’t have a workplace plan or even when you’re self-employed.
Harish said his income is too high for an IRA, but didn’t mention if he has a retirement plan at work. If not, he could get the full tax deduction with a traditional IRA because it doesn’t come with an income limit.
However, when you or a spouse have a workplace retirement plan, the deductibility of your contributions to a traditional IRA may be reduced or eliminated based on your income. Arthur asked if his IRA contributions would be deductible when he maxes out a 401(k). Here are the limits you need to know.
For 2019, if you’re a single taxpayer with modified adjusted gross income (MAGI) over $74,000, you can’t deduct any traditional IRA contributions when you also participate in a retirement plan at work. This is the case no matter if you max out the plan or not.
If you’re married, file taxes jointly, and have your own workplace retirement plan, you can’t deduct traditional IRA contributions when your household MAGI exceeds $123,000. And if you don’t have a retirement account at work but your spouse does, traditional IRA contributions are not tax-deductible when your household income exceeds $203,000.
To clarify, you can still contribute to or max out both a workplace plan and a traditional IRA in the same year, no matter how much you earn. But you just may not get the full tax benefit for the IRA contributions. I’ll tell you more about making non-deductible IRA contributions in a moment.
3. Use a Roth IRA when you qualify.
Another way to use multiple retirement accounts wisely is to pair your workplace plan with a Roth IRA. But as I mentioned, you can’t contribute to a Roth IRA when your income exceeds the limit for your tax filing status.
For 2019, single taxpayers are shut out of a Roth IRA when they have MAGI above $137,000. If you’re married and file taxes jointly, you are ineligible for a Roth IRA when your income exceeds $203,000.
The Roth offers some nice benefits that can outweigh a traditional IRA. In general, the younger you are and the more time you have before retiring, the more a Roth makes sense.
In general, the younger you are and the more time you have before retiring, the more a Roth makes sense.
But Harish and Marta both mentioned that they earn too much to be eligible for a Roth IRA. When you don’t qualify for a Roth IRA and you also have a workplace retirement plan, you’re left with two account options: a nondeductible IRA or a taxable brokerage account.
4. Use a nondeductible IRA as a last resort.
If you’re like Marta and have income that’s too high to qualify for a Roth IRA or for a fully deductible traditional IRA (because you also have a workplace plan), consider a nondeductible IRA your last resort for a tax break.
A nondeductible IRA is simply a traditional IRA funded with after-tax dollars. However, even though you don’t get an immediate tax benefit for contributions, your earnings in a nondeductible IRA are still tax-deferred. In other words, as your non-deductible balance grows, you avoid tax on gains and dividends until you take withdrawals in retirement.
Here’s an important tip: Instead of mixing deductible and non-deductible contributions in the same IRA, open another IRA to keep the two types of contributions separate. Also, be aware that if you make non-deductible contributions you must submit IRS Form 8606 when you file taxes.
Having this recordkeeping is one downside to a nondeductible IRA. It’s your responsibility to keep up with the amount of deductible versus nondeductible contributions in your traditional IRA. Otherwise, you and the IRS won’t know whether you owe tax on future withdrawals from the account and you could end up paying tax twice!
Another confusing aspect of a nondeductible IRA is that the IRS treats all of your traditional IRA assets as a single IRA when you start taking withdrawals. It’s a bit complicated, but when you have both deductible and nondeductible contributions (even in separate accounts) only a portion of your investment gains in the account may be tax-free.
5. Consider converting a nondeductible IRA to a Roth.
To sum up, it’s always better to contribute to a Roth IRA or a traditional IRA when you can. But if you contribute to a nondeductible IRA, another option is to convert it to a Roth IRA, known as a “backdoor Roth IRA.” This is a way for high earners, who are ineligible to contribute to a Roth IRA, to still have one using a workaround strategy.
Once a year you can make a nondeductible IRA contribution and then convert it to a Roth IRA. When you do a Roth conversion, you must pay tax on any amount that wasn’t previously taxed.
Note that a Roth conversion can be a bit complicated if you’ve had your IRA for a while or you have a mix of nondeductible and deductible IRAs. So be sure to contact your IRA custodian or provider for conversion instructions. Also, as I previously mentioned, don’t forget to submit IRS Form 8606 with your tax return any time you make nondeductible contributions to an IRA.
Free Resource: Retirement Account Comparison Chart (PDF download)– get the rules for the most popular retirement accounts
Should You Contribute to a Nondeductible IRA or a Taxable Account?
The major benefit of making contributions to a nondeductible IRA is that you defer taxation on growth in the account. That’s a nice benefit because you get to skip paying tax on earnings in the account until you withdraw them.
The remaining investment vehicle that anyone with any amount of income or any retirement account can use is a regular, taxable brokerage account. You must pay capital gains tax rates that can be as high as 20% for investments owned more than a year.
In contrast, you pay ordinary income tax rates on withdrawals from retirement accounts. The 2018 income tax brackets range from 10% up to 37%, depending on how much you earn.
Whether you’d pay more or less tax using a nondeductible IRA or a brokerage account really depends on a variety of factors, such as what investments you own, how long you own them, and how much you earn.
So, I can’t give you a definitive answer about whether you’ll come out ahead with a nondeductible IRA or a brokerage account. The best way to know is to consult with a tax or financial planner about the pros and cons of contributing to a nondeductible IRA when you also have a retirement plan at work.
Also, as I mentioned, the recordkeeping for a non-deductible IRA can be tricky. So if you’re not extremely organized, don’t have a great tax accountant, or don’t know the exact investments you have in your IRA, I don’t recommend entering into nondeductible IRA territory. The downside is that you could wind up paying more in taxes, instead of less.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
