April 15 isn’t just the deadline for filing your taxes; it’s also the last day that you can make a 2009 IRA contribution. With that in mind, I thought it might be helpful to talk about the circumstances under which you should consider funding a Nondeductible IRA. While anyone with earned income can contribute to a Traditional IRA, the tax deductibility of your contribution depends upon whether you have access to a workplace retirement plan, and, more importantly, your Modified Adjusted Gross Income (MAGI). If you’re not sure whether your IRA contributions are tax-deductible, check out these tables from irs.gov:
Who Should NOT Contribute to a Nondeductible IRA
Ok, if you’ve looked at the above tables, and your IRA contributions are deductible for 2009, then there’s no reason to worry about nondeductible contributions. The same is true if you’re eligible to contribute to a Roth IRA (MAGI < $176k if married filing jointly, MAGI < $120k if single). Generally speaking, you should contribute to your 401(k) up to the employer match, then fund a Roth or (deductible) Traditional IRA, and then max out the remaining portion of your 401(k), all before considering nondeductible IRA contributions or taxable investments.
Who Should Consider Funding a Nondeductible IRA
Contributing to a Nondeductible IRA could prove to be advantageous under the following circumstances:
1) You’re not eligible for a Roth IRA
2) You’ve already maxed out your 401(k)
3) You won’t need the money before age 59 ½
4) You could use more tax-advantaged space for Bonds, REITs, and other tax-inefficient investments
If you meet the above criteria, a Nondeductible IRA could provide a valuable means for tax-deferred growth. When compared to investing in a taxable account, the relative advantage of a Nondeductible IRA depends upon your time until retirement (a longer time horizon adds to the advantage), future tax rates (higher capital gains rates increase the advantage, higher marginal rates reduce it), and the type of investments (a higher percentage of tax-inefficient assets adds to the advantage). If you want to run some numbers, check out this spreadsheet from The Finance Buff.
Beginning this year (2010), there is another reason to consider a nondeductible IRA contribution. Since the $100,000 MAGI limit on Roth IRA conversions has been eliminated, your nondeductible IRA contribution could potentially be converted to a Roth IRA. Of course, the IRS considers the value of all of your IRAs when calculating the conversion tax, so conversion isn’t a no-brainer, but worth considering.
The Mechanics of a Nondeductible IRA Contribution
The term “Nondeductible IRA” often causes confusion. To contribute to a Nondeductible IRA, you simply make a contribution to an existing Traditional IRA or open a new Traditional IRA. Regular contribution limits still apply, and withdrawals are still taxed at ordinary income rates. When you file your taxes, you will use IRS Form 8606 to report your nondeductible contributions and track your cost basis. This form gets more complex when you withdraw funds from your IRA or pass it along to heirs, so if you file your own taxes, make sure that you’re comfortable with the instructions.
In summary, for investors who prioritize simplicity or have plenty of tax-advantaged investing space, funding a Nondeductible IRA isn’t necessary. For some, however, this often-overlooked tactic can provide a valuable source of tax-deferred growth when other tax-advantaged investment options have been exhausted.
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