If you’re raking in the big bucks, it just might make sense to stash after-tax money into an IRA.
Putting money into an individual retirement account brings a bevy of benefits. Savers can put away up to $5,500 this year in a traditional IRA, plus $1,000 if they’re 50 and over. Money in this account grows on a tax-deferred basis over time.
Here’s the kicker: In 2018, workers with a modified adjusted gross income of up to $63,000 ($101,000 if married), can take a deduction on their income taxes up to the amount of their contribution limit.
If your income places you above the threshold for the deduction — or if you earn too much to make a Roth contribution for 2018 — a nondeductible IRA contribution with after-tax money may be worth considering.
“Many of our clients are phased out of making deductible contributions to an IRA or direct contributions to a Roth IRA,” said Jane DeLashmutt O’Mara, portfolio manager with FBB Capital Partners in Easton, Maryland.
“For those who want to build a larger tax-deferred savings bucket, this is one way to do so,” she said.
These are the upsides — and downsides — of stashing nondeductible contributions into an IRA.
When you reach retirement and begin taking withdrawals from your traditional IRA, your pretax contributions and their earnings are subject to income taxes.
If you make a “nondeductible” IRA contribution, you’re using after-tax money to do so. These funds count as your basis or the amount of your capital investment for tax purposes.
This means that when you take this money out as a distribution from your IRA, you’re effectively getting your money back — and it should come back to you free of income taxes.
Here’s the catch: Any money you invest in a traditional IRA, whether deductible or not, is accruing earnings, which will be subject to income tax at withdrawal.
“You may build your basis in the account, but those assets aren’t growing tax-free,” said O’Mara.
Difficulties may arise as you make your nondeductible contributions.
For instance, your IRA custodian won’t necessarily track your basis from these investments, which places you at risk of accidentally paying income taxes twice on your nondeductible contributions.
“If I make a nondeductible contribution, I don’t have to pay taxes on it, but I must pay taxes on the earnings,” said Rich Ramassini, director of strategies and sales performance at PNC Investments.
“Now I have to be specific and record-keep it so that I’m paying taxes on the right amount of money,” he said.
Don’t forget: The IRS needs to know about your nondeductible contributions. Report them, along with any distributions or Roth conversions, on Form 8606.
Further, if you leave your nondeductible contributions in a traditional IRA, they will be subject to required minimum distributions when you turn 70½. RMDs do not apply to money in Roth IRAs.
There’s a right way and a wrong way to make a nondeductible contribution to a traditional IRA.
For instance, since you’ve already paid income taxes on this money, you can generally convert it to a Roth IRA where earnings grow tax-free. It’s best to do this right away so that your investment doesn’t accrue gains in the meantime.
This strategy, known as a “backdoor Roth conversion,” may make sense if your tax rate is lower than what you expect it to be in the future.
Singles with a modified adjusted gross income of at least $135,000 ($189,000 if married and filing jointly) cannot contribute to a Roth directly, so they may find this strategy valuable.
Be aware that the Tax Cuts and Jobs Act has made Roth conversions somewhat riskier: You can’t reverse a conversion you make in 2018 and savers who made a Roth IRA conversion in 2017 have until Oct. 15, 2018 to undo it.
Also, if you have multiple IRAs, a backdoor Roth could come with a nasty tax bite. In this case, the IRS assesses the tax based on the combined balances of your all IRAs and not just the amount that you’re converting.
If you still want to hold nondeductible IRA contributions without converting them immediately, you should keep that cash separate from any IRAs that have pretax contributions, said O’Mara.
“That keeps the account purely nondeductible, but you do have to track your contributions and your basis in that account,” she said.
Consult your CPA or financial planner before you consider making a nondeductible contribution, since it’s a strategy that can carry risks and rewards.
“These are the types of decisions that are best made proactively as you build your plan,” said Ramassini.
- Diversify your tax picture: As you prepare for retirement, it’s best to have a combination of taxable, tax-deferred and tax-free accounts. Bear this in mind as you consider whether to make that nondeductible IRA contribution.
“You’ll want some levers to pull in terms of managing your taxable income and how much money goes into your pocket versus Uncle Sam’s,” said O’Mara.
- Bulk up your emergency fund: If you have some spare cash lying around, maybe it’s better to build your emergency fund as opposed to locking it up in a tax-deferred account. Don’t forget you’re subject to a 10 percent penalty for early withdrawals until you’re 59½.
- Put thought into that backdoor Roth conversion: You no longer have access to a “do-over” of any cash you convert to a Roth IRA this year. Lower income tax rates today might make this move attractive now, but be sure it’s right for you.
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