The Money Mustache Community
Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: DreamingofFreedom on February 07, 2013, 06:36:48 AM
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I put a bit of money in what I thought was a traditional IRA this past year. My tax program now tells me that it will be treated like a nondeductible IRA instead. I understand that this means I won't get to take the IRA contribution from my pretax income, but the returns will not be taxed until I withdraw them. When I do withdraw the money, I think my basis will be adjusted to show that I already paid tax on the initial contribution.
Do any of you have thoughts on whether nondeductible IRAs are worth contributing to? I found an article online that said they would make a big difference in tax liability if I kept bonds or high dividend stocks in them. Of course, the price I would be paying is that the money is much less accessible than a standard taxable investment account. There's always the backdoor ROTH conversion option, but haven't I already paid taxes on the money? Would I then need to pay taxes again to convert to a ROTH?
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Nondeductibles are a massive PIA when you withdraw or convert to Roth (assuming you also have other, standard IRAs). Any withdrawal from a non-Roth is treated by the IRS as a withdrawal from your "one" giant IRA; thus, to take advantage of no taxation on your original contribution to the nondeductible account, you need to do a valuation of all non-Roths as of year end, then pro-rate the nondeductible contributions to arrive at what you are not taxed at. For example, we did small, placeholder Roth conversions this year (to start 5 year clock) and had to deal with nondeductibles that we made in the early 90s. After running the numbers, ended up keeping 1 or 2 % of the conversion from being taxed. (And, you'll need to keep your last form 8606 at hand until you withdraw/convert). Even if the nondeductible is your only IRA at retirement, you'll have to do this to enable taxation on your capital gains/accumulations in the account.
You should convert to Roth post-haste, particularly if you don't have other non-Roth IRA outstanding. The most tax you would then owe would be the gains in the account since you made the original contribution. If you have other non-Roth accounts, you would be subject to the pro-ration requirements.
To confirm what I've written above, you should become familiar with IRS Publication 590, your guide to IRA tax law: http://www.irs.gov/uac/Publication-590,-Individual-Retirement-Arrangements-(IRAs)
Steve
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Do any of you have thoughts on whether nondeductible IRAs are worth contributing to? I found an article online that said they would make a big difference in tax liability if I kept bonds or high dividend stocks in them. Of course, the price I would be paying is that the money is much less accessible than a standard taxable investment account.
I have also considered contributing to a nondeductible IRA since I am not eligible to contribute to a deductible traditional IRA or a Roth IRA, but I decided to go with muni bonds in taxable instead because of the accessibility issue. I am also curious to hear others' thoughts.
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I agree with TN_Steve, you should convert to a Roth. I actually found myself in the same situation as you this year, where I had already contributed to a Traditional IRA but it turned out that due to my high income and 401k plan at work I was not eligible to deduct the Traditional IRA contributions.
The IRS lets you convert contributions from Traditional IRA to Roth IRA in a given year as long as you do it before you file your taxes. So you'd just transfer the money from the TIRA to the RIRA. Then on your tax forms you will mark it as contributions made to the Traditional and then reconstituted as a Roth, and you will only pay taxes on it once. That way you at least get the benefits of a Roth IRA, instead of the next-to-none benefits of a non-deductable Traditional IRA.
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Thank you for all the responses! This is the only IRA I have, so it sounds like I should be looking into the ROTH conversion as soon as possible. I should have educated myself more about my eligibility before opening it. I just didn't know that because I have a 401(k) plan, my IRA options are limited.