The highest concern for many savers is their retirement plan or savings. Saving now for retirement will make sure that when you quit or minimize the number of hours you work, you have enough money to enjoy a decent standard of life.
It can be an ideal way to decrease your taxable income to contribute to an individual retirement arrangement. But, your IRA contributions will not be tax-deductible if your company provides a 401(k), you have a high income or you are contributing to a Roth IRA.
In that case, it may still be a smart idea to make nondeductible IRA contributions, if you can prevent some frequent and costly pitfalls. Read on to learn about the pros and cons of a nondeductible IRA.
Unlike a traditional tax-deductible IRA, after-tax dollars make non-deductible IRA contributions that have no immediate tax advantage. So, as you can for a traditional IRA, you can not subtract contributions from your revenue taxes.
However, your nondeductible contributions are gradually tax-free. Many people resort to these alternatives because their income is too large for the IRS to allow them to make contributions to a regular IRA that are tax-deductible.
Contributing to a Nondeductible IRA
You can each contribute to an IRA in a given tax year as long as you or your spouse have enough earned or self-employed income. For 2020 and 2021, if you are 50 years or older, the cap is $6,000, with an extra catch-up contribution of $1,000.
When required minimum distributions (RMDs) have to begin, you can keep having contributions until the year that you reach age 72. The age of RMD was originally 70.5 but was extended to 72 after December 2019.
Advantages of a Nondeductible IRA
Many individuals go to nondeductible IRAs because they are excluded by certain requirements from making tax-deductible contributions to traditional IRAs, but they also want access to a stable mechanism for retirement savings.
For example, when invested in the account, all capital gains and dividends your contributions create will not be taxed. In some situations, all or a portion of the money you withdraw will be tax-free. That is because your retirement savings can’t be taxed twice by the government.
Tax-deferred growth is the benefit of having a non-deductible contribution. Tax-deferred growth can be very useful because a difference of only a few percent in return can make a big difference over a long period of time in the amount you gain.
But, before you make a nondeductible contribution, make sure that you are pursuing tax-advantaged growth, you know the rules and consider your options.
Disadvantages of a Nondeductible IRA
Nondeductible IRAs that are converted to Roth IRAs promptly can be good. On the other hand, permanent nondeductible IRAs have some drawbacks. You might probably have to pay more taxes than you need to if you do not hold deductible and nondeductible contributions separate.
That’s because it’s tough to maintain the two straight once you’ve fused deductible and nondeductible contributions. However, you can do it so long as you document your contributions. It is your duty to keep track of any nondeductible contributions and claim them.
To record your contributions and distributions, the IRS suggests keeping your 1040 and 8606 forms and Form 5498 that you receive from the IRA custodian per year. This is vital because the cost basis is not lost and transfers to the spouse or beneficiary upon the passing of the IRA owner.
Contributing to a nondeductible IRA can be a way to cover some or all of your retirement savings from tax on the way to a backdoor Roth conversion, but if you’re thinking about storing your money in a nondeductible IRA for the longer run, it’s important to weigh the risks.
Consult your financial advisors and evaluate your options if you’re considering making nondeductible IRA contributions. In the event that you make no-deductible contributions, keep precise records.