The Value of Making Non-Deductible IRA Contributions
For high-income earners who often find themselves phased out of many tax deductions, the rules around saving for retirement are no better. However, there is one complex yet beneficial maneuver available: non-deductible contributions to a traditional IRA.
While contributions to traditional IRAs are typically appealing because they can be deducted from your taxable income, those with higher earnings may hit income thresholds that disallow this deduction. The opportunity to make non-deductible contributions, though, remains a viable strategy
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The income limitations for making deductible contributions to a traditional IRA can vary depending on your filing status and whether you or your spouse are covered by a retirement plan at work. Here’s a breakdown of the income limits for 2024:
For Single Filers:
If you are not covered by a workplace retirement plan, you can make a fully deductible contribution to a traditional IRA regardless of your income level.
However, if you are covered by your employer’s retirement plan, the amount you can deduct begins to phase out at a Modified Adjusted Gross Income (MAGI) of $77,000 and is completely phased out at $87,000.
2. For Married Couples Filing Jointly:
If both parties are covered by a workplace plan, the deduction begins to phase out at a MAGI of $123,000 and phases out completely at $143,000.
However, if you are not covered by a plan but your spouse is, your deduction begins to phase out at $230,000 and phases out completely at $240,000.
3. For Married Filing Separately:
If you or your spouse is covered by a retirement plan at work and you file separately, the phase-out starts at $0 and ends at $10,000, making it challenging to claim any deduction if you earn above this modest threshold.
Non-deductible contributions to traditional IRAs allow individuals whose income exceeds the IRS thresholds for deductible contributions to still benefit from tax-deferred growth. Essentially, while the contributions themselves do not reduce your taxable income in the year they are made, the earnings on these contributions grow tax-deferred until withdrawal.
This feature is particularly compelling because it offers tax-advantaged growth, similar to the benefits received from a Roth IRA, but without the income limitations that restrict contributions to such accounts.
However, with these benefits comes the responsibility of meticulous record-keeping. It is imperative to file Form 8606 with your tax return each year you make a non-deductible contribution to a traditional IRA. This form helps track the total basis in your IRA contributions, which is essential when you begin taking distributions in the future.
Your IRA’s basis represents the portion of your funds that have already been taxed (your non-deductible contributions) and should not be taxed again. But failure to file Form 8606 will allow the IRS to assume that all distributions taken in the future are fully taxable as ordinary income, leading to a form of double taxation.
By keeping accurate records and utilizing IRS Form 8606, high-income earners can ensure that they maximize the benefits of their retirement savings efforts without unwelcome tax surprises in later years. To simplify record-keeping and reduce the likelihood of errors, a sensible approach is to open a separate traditional IRA, dedicated solely to these contributions, thus isolating non-deductible contributions in their own account and creating a clear distinction between pre-tax and after-tax funds.
This strategy can be especially beneficial if you hold multiple retirement accounts or regularly contribute to both deductible and non-deductible IRAs, as it minimizes the risk of commingling funds and complicating future tax calculations. And when it is time to calculate the taxable and non-taxable portions of distributions or make Roth conversions, having a separate account streamlines the process and reduces the chances of costly mistakes.
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Malcolm Ethridge, CFP® is the Managing Partner at Capital Area Planning Group, based in Washington, D.C. He is also the Managing Partner of Capital Area Tax Consultants.
Malcolm’s areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
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Disclosures:
The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.
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