Are Nondeductible IRAs A Good Choice For You?

 

If you’re in a company retirement plan and your 2013 adjusted gross income exceeds certain levels ($69,000 for singles and heads of household; $115,000 for married people filing jointly), you can’t deduct contributions to an IRA. You can still make contributions (up to the usual annual limits), but if they’re not deductible, why would you do so?

Here are three possible reasons:

1. Earnings within an IRA are tax-free and thus compound at a higher rate.

2. Only the earnings are taxed when the funds are withdrawn. Since the initial contributions weren’t deductible, their subsequent distribution isn’t taxable. (In IRAs funded by deductible contributions, withdrawals are 100% taxable.)

3. Under certain conditions, you can convert a nondeductible IRA to a Roth IRA. This could be useful where you want to fund a Roth but your income level disqualifies you from doing so directly.

Caveat: If you have two or more IRAs, you can’t attribute withdrawals to just one of them, even if that’s the only one you actually withdrew from. A distribution from one IRA will be treated as a pro-rata distribution from all of your IRAs. Thus, if you have one IRA that was funded by nondeductible contributions and another that was funded by deductible contributions (where all withdrawals are taxable), the two will be lumped together to determine a combined taxable withdrawal percentage.

In some situations your funds might be better used elsewhere. You’d generally be wise to liquidate high-interest debt (such as credit card balances) before investing in a nondeductible IRA. You should also compare your potential earnings within the IRA to outside investments offering higher after-tax returns, adjusting, of course, for relative risk. Since funding a nondeductible IRA is only one among many possible investment strategies, always review your options with your financial adviser before proceeding.

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