What’s a non-deductible contribution to traditional IRA? Why it’s a bad idea?

A few weeks ago, I wrote about Roth IRAs and discussed the types of investors most likely to benefit from a Roth IRA. On this post, I want to talk about an IRA contribution I don’t like so much and I don’t think you should either.

Everyone can contribute to a traditional IRA up to $5,500 a year ($6,500 if you are 50 or older). Many people believe that a traditional IRA contribution is by definition tax deductible like their 401k. Unfortunately, neither of those beliefs are true. The deductibility of your traditional IRA phases out when you make too much money. How much is too much? In 2017, if you make more than 72K a year as a single filer or $119K a year as a married couple file jointly, you’ve made too much according our IRS. Your contribution to your traditional IRA is a non-deductible contribution or an after tax contribution.

What does it mean to make a non-deductible contribution to your traditional IRA? Let me give you two examples.

Example #1: James, as a single filer, made less than 60k a year for the last five years and made more than 72k this year. He made a total contribution of $15,000 in the last five years to his traditional IRA and $5,000 to his traditional IRA this year. His traditional IRA account totaled $20,000. Within this $20K, ¼ of it is post tax and ¾ of it is pre-tax. James is required to file a 8606 Form to inform IRS that part of his traditional IRA is after tax so he can avoid getting taxed again when he withdraw his money. Note, there is a $50 penalty for not filing 8606 when required, but it’s to James’s advantage to file this form.

Example #2: When James turned 59 ½ years old, he withdraws from his traditional IRA account. Now, his account is worth $200,000 growing from the original $20,000 (10 times the original amount). Within this account, still ¼ of it is post tax contribution and ¾ of it is pre-tax contribution. Withdrawing $1000 from this account means $750 is taxed at his current federal income tax rate. Of the $250, 1/9th of it is his original contribution which was post tax thus tax free on withdrawal; 8/9th of it is growth which is taxed at his current federal income tax rate.

Are you screaming yet? If not, let me break down what you are missing:

  • The greatest benefit of contributing to your traditional IRA, like your contributions to your 401k, is to reduce your taxable income. It is to shave off your AGI (Adjusted Gross Income) from the top so it reduces your income that is taxed at the marginal rate (the highest taxed portion). If your traditional IRA is not getting you the taxable income reduction, it is missing its most important function.
  • When you withdraw this money in retirement, the growth of your non-deductible contribution is not only taxed and its taxed at your ordinary income tax rate! That’s a double whammy in my head. Had you contributed that amount to a backdoor Roth IRA, your withdrawal of contribution AND growth are tax free! Or if you had contributed to a taxable account, your contribution is tax free and its growth is taxed at long term capital gains rate which is a lower rate.
  • Since we brought up the comparison to a taxable account, you must understand your IRA contributions are not liquid, meaning you cannot withdraw without a penalty until you turn 59 ½, whereas your taxable account can be withdrawn whenever you desire.

Have I convinced you a non-deductible contribution to your traditional IRA is a bad idea yet? So what can you do about it? Here’s what I think:

  1. Have you maxed out your 401k contributions yet? If you have not, your priority here should be maxing out your 401k. Don’t bother making contributions to your IRA, especially if it’s going to a non-deductible.
  2. Converting your non-deductible IRA contributions to your Roth IRA. Wait a minute, can’t you do that? Absolutely, it’s called a backdoor Roth IRA. I do it every year. So do many high income professionals. If your income exceeded direct Roth IRA contribution limit and you’ve already maxed out your 401k, backdoor Roth IRA is your next step.
  3. Contribute to a good old taxable account and invest there! I wrote about it in the previous posts in Part 1 and Part 2, taxable accounts are great ways to invest. Don’t feel like you are missing out because you don’t have any more tax sheltered space. Taxable accounts are where the majority of your wealth will end up like the majority of a high income professional.

What do you think? Have you been making non-deductible contributions to your traditional IRA? Have you filed a 8606 for them? Leave me a comment.

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