Nondeductible IRAs: How they often become backdoor Roth conversions

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A non-deductible IRA offers one of the two major tax-savings benefits of a traditional IRA: the ability to grow your money tax-deferred until you take it out in retirement. The benefit it lacks – and why it’s called non-deductible – is that a worker’s contribution is not made with pre-tax funds but rather with after-tax funds, meaning it does not receive a tax break on contributions.

Here’s how a non-deductible IRA works and how you can use it to convert to a Roth IRA.

How a non-deductible IRA works

One of the more valuable benefits of a deductible IRA is the ability to make contributions with pre-tax income. This feature allows you to avoid taxes on any money you put into the account. Only when your money comes out is it taxed as if it were income. So the deductible IRA allows you to effectively defer your income until retirement, while allowing you to defer taxes on any earnings.

In contrast, the non-deductible IRA still offers you the tax-deferred growth of a traditional IRA, but you don’t get to deduct the contribution from this year’s income and lower your taxes. And since you paid taxes when the money went into the non-deductible IRA, you won’t pay taxes when your contribution (but not your earnings on that contribution) comes back out.

So without that extra tax advantage, why would anyone use a non-deductible IRA?

The reason is that some workers have no choice. The Internal Revenue Service (IRS) prohibits anyone making too much income from taking a deduction for their traditional IRA contribution. At the same time, income restrictions may prevent direct contributions to the other major IRA type, the Roth IRA. So if you want to contribute to an IRA, you may have no option but to use a non-deductible IRA.

Despite the lack of a tax break, the non-deductible IRA can still prove valuable in a couple ways.

A non-deductible IRA can be converted into a Roth IRA

“Many people are not eligible to make a deductible IRA contribution or a Roth IRA contribution so they contribute to a non-deductible IRA to have tax-deferred growth or as a way to allow them to convert to a Roth IRA,” says Jeffrey Corliss, CFP, managing director and partner with RDM Financial Group at Hightower in Westport, Connecticut.

So the non-deductible IRA does get you the benefit of tax-deferred growth, but the Roth IRA can do that as well, and the Roth IRA offers other valuable tax and estate-planning benefits, too.

For many people, particularly higher earners, the non-deductible IRA is just a stop on the way to converting those funds into a Roth IRA, via a “backdoor Roth IRA.” But a conversion has other considerations that may trip you up, including the IRS’s pro rata rules, which may create further tax liabilities. So if your plan is to convert into a Roth IRA, it’s vital to understand all the rules.

All the pros and cons of conversion can be tricky to calculate, and Corliss suggests using a financial advisor to help you avoid paying any unnecessary taxes. Taxes can be significant if you’ve built up earnings in a non-deductible IRA over many years. He also suggests looking into a multi-year conversion strategy, moving only a portion into a Roth IRA each year.

“If you stagger conversions into different tax years, this may keep your taxable income below the next tax bracket,” he says.

Even if you do keep the non-deductible IRA, you’ll want to pay particular attention to the rules.

“If you do not convert to a Roth IRA, make sure you keep track of your contributions and any gains since it is your responsibility to ensure when you are withdrawing funds that the tax is accurately calculated,” says Corliss.

Income restrictions on deductible traditional IRAs

The good news for workers is that, regardless of your earned income, you can always contribute to a non-deductible IRA and receive tax-deferred growth, though you won’t be able to contribute with pre-tax funds. But if you’re looking to contribute with pre-tax money, you may be limited.

The table below shows the adjusted gross income thresholds for deductibility in 2021, including when the deductibility of your contribution phases out and stops completely. During the phase-out period, you’ll be able to receive partial deductibility for your contribution. The limits also depend on whether one spouse or other is covered by a workplace plan.

IRA tax-deductibility by income for taxpayers covered by a workplace retirement plan

Filing status Fully deductible Phase out Non-deductible
Individual Up to $66,000 $66,000-$76,000 $76,000+
Married filing jointly* Up to $105,000 $105,000-$125,000 $125,000+
Married filing jointly** Up to $198,000 $198,000-$208,000 $208,000+
Married filing separately $0 $0-$10,000 $10,000+

Source: IRS
* Where the spouse making the IRA contribution is covered by a workplace retirement plan. 

** Where the spouse making the IRA contribution is not covered by a workplace plan, but the other spouse is covered.

Importantly, if you and your spouse are not covered by a workplace retirement plan, you will not have any phase-out for deductibility. So you will be able to contribute to a deductible IRA.

Bottom line

You can use a non-deductible IRA to enjoy tax-deferred growth on an investment if you’re unable to take advantage of the deductibility in a traditional IRA. However, it’s more typically only a way for higher-income workers to get into financial advisors’ favorite retirement account, the Roth IRA. But it can’t be stressed enough, pay close attention to all the rules on conversion so that you don’t run afoul of IRS rules and rack up a tax bill that could have easily been avoided.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
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