Author Topic: Is a non-deductible IRA any good?  (Read 3248 times)

rockstache

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Is a non-deductible IRA any good?
« on: June 29, 2016, 08:38:52 AM »
Hi all. Investing isn't my forte, although I find it fascinating, so I have tended to keep things pretty simple. I have read the stock series many times, and recently purchase the book as well (thanks to an Amazon credit it was free actually). Now I am struggling to understand where to go from here.

Up until this point, I have maxed out our t-IRAs at the beginning of the year ($5,500 each). Now however, our (DINKs - no immediate plans to change that) income is creeping up to the level where we will no longer be eligible for the full deduction on our t-IRAs, possibly beginning next year. Jim Collins suggests that a non-deductible IRA adds complexity and confusion to taxes, and I do NOT want any additional complexity. So here are my questions:

-Is a non-deductible IRA where my money contributed over the deductible limit will go? For instance if I contribute $5500 and can only deduct $4500, does the rest automatically go to a new 'non-deductible bucket,' or do they just tax me on it that year when doing my taxes (which I do myself on turbotax hence the desire for simplicity).
-At the beginning of the year when I fund the IRAs, I don't know what our AGI will be for the year. Our raises and bonuses vary, and sometimes we may have tuition to deduct. Should I still fund the full $5500?
-If yes above, how do I track what is deductible and what is not, and how long do I have to track it, and what do I need to do with said tracked info.
-At what point (if any) do I cease funding the IRA at all?

Any other tips? We do already max both 401ks and we do not have an HSA available at this time. I will admit to some fear and lack of knowledge regarding health insurance, and I do need to look into that stuff before the next open season. If there is no more tax advantage space left for us, that's fair, I just want to be sure to use what I can before I start padding the taxable account. We have no house, and we have no 529 or plans for one. 

Thanks in advance for the help.

Jack

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Re: Is a non-deductible IRA any good?
« Reply #1 on: June 29, 2016, 08:56:10 AM »
Go read about "backdoor Roth IRA" and "mega backdoor Roth IRA."

seattlecyclone

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Re: Is a non-deductible IRA any good?
« Reply #2 on: June 29, 2016, 09:13:54 AM »
If your incomes are just barely at the threshold for the IRA deduction, I recommend making Roth contributions for whatever part of the $5,500 wouldn't be deductible. Roth is better than non-deductible traditional in essentially every case because you'll pay tax on any gains in the non-deductible traditional account but you generally won't in a Roth account.

-Is a non-deductible IRA where my money contributed over the deductible limit will go? For instance if I contribute $5500 and can only deduct $4500, does the rest automatically go to a new 'non-deductible bucket,' or do they just tax me on it that year when doing my taxes (which I do myself on turbotax hence the desire for simplicity).

Yes, any amount over the deduction limit will be non-deductible. However you have to fill out Form 8606 to tell the IRS about it so that you get credit for the non-deductible basis in the future when you withdraw from the account.

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-At the beginning of the year when I fund the IRAs, I don't know what our AGI will be for the year. Our raises and bonuses vary, and sometimes we may have tuition to deduct. Should I still fund the full $5500?

If you're doing full traditional, you can put all the money in right away and then you report which part was non-deductible on Form 8606 when you do your taxes. If you go for Roth contributions instead, there is a way to "recharacterize" contributions from traditional to Roth later in the year if you find out your income wasn't what you thought it would be. I personally think that's too much hassle. In the past if I knew I could contribute at least $3,000 but maybe not the full $5,500 (for example), I would contribute $3,000 right away and then wait until I know what my income is before doing the rest. This is perhaps slightly less optimal than making a full contribution right away and then recharacterizing later, but it's really not that bad.

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-If yes above, how do I track what is deductible and what is not, and how long do I have to track it, and what do I need to do with said tracked info.

If you go with non-deductible traditional, you'll have to fill out that Form 8606. You'll probably then want to save your tax returns indefinitely as a record of what portion of your IRA is post-tax so that you don't get taxed on it again at the time of withdrawal.

With Roth, you should also be keeping records indefinitely so that you can show which portion of your withdrawal came from contributions vs. conversions vs. earnings if you end up doing early withdrawals.

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-At what point (if any) do I cease funding the IRA at all?

Never! Tax-advantaged accounts are your friend. See https://seattlecyclone.com/accessing-your-retirement-accounts-early-yes-you-can/ for more information about why you shouldn't worry about putting "too much" in there for an early retirement.

LAL

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Re: Is a non-deductible IRA any good?
« Reply #3 on: June 29, 2016, 09:22:26 AM »
follow.

rockstache

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Re: Is a non-deductible IRA any good?
« Reply #4 on: June 29, 2016, 10:35:20 AM »
Go read about "backdoor Roth IRA" and "mega backdoor Roth IRA."

I have, repeatedly (Mad Fientist etc), but I have a really hard time understanding them and I can't see how they could apply to me. We do already have Roth accounts, so I think I would have to empty them to begin this process (?) and it seems overwhelmingly confusing.


Thanks Seattle! A couple of follow up questions:

-Why would I want to fund an Roth IRA if I was over the deductible limit? At that point, don't I have to start keeping an eye on the Roth limits?
-How do I determine exactly what my AGI will be? I have used a bunch of calculators in the past, but they all seem to be estimates and not terribly accurate.
-How do I determine how much I am eligible to deduct exactly? The IRS site states that a portion can be deducted, but I don't see where they list exactly how much.
-I sort of get the pipeline conversion. However, I dismissed it initially because my husband and I are probably never going to be very good mustachians with $15k expenses. So I wasn't sure if it made much of a difference whether we converted to Roth and paid high taxes, or just saved directly in the taxable account and paid high taxes. Unlike many people here, math is not my best friend.

-Who could help me to understand this stuff better? Could I hire a CFP? A fee based advisor? Someone to do my taxes? I feel like I am beyond the very basics, and our income is starting to grow, and my level of knowledge needs to keep up.

Thank you for the article link - I'm reading as fast as I can.

Yankuba

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Re: Is a non-deductible IRA any good?
« Reply #5 on: June 29, 2016, 10:42:55 AM »
Go read about "backdoor Roth IRA" and "mega backdoor Roth IRA."

I have, repeatedly (Mad Fientist etc), but I have a really hard time understanding them and I can't see how they could apply to me. We do already have Roth accounts, so I think I would have to empty them to begin this process (?) and it seems overwhelmingly confusing.


Thanks Seattle! A couple of follow up questions:

-Why would I want to fund an Roth IRA if I was over the deductible limit? At that point, don't I have to start keeping an eye on the Roth limits?
-How do I determine exactly what my AGI will be? I have used a bunch of calculators in the past, but they all seem to be estimates and not terribly accurate.
-How do I determine how much I am eligible to deduct exactly? The IRS site states that a portion can be deducted, but I don't see where they list exactly how much.
-I sort of get the pipeline conversion. However, I dismissed it initially because my husband and I are probably never going to be very good mustachians with $15k expenses. So I wasn't sure if it made much of a difference whether we converted to Roth and paid high taxes, or just saved directly in the taxable account and paid high taxes. Unlike many people here, math is not my best friend.

-Who could help me to understand this stuff better? Could I hire a CFP? A fee based advisor? Someone to do my taxes? I feel like I am beyond the very basics, and our income is starting to grow, and my level of knowledge needs to keep up.

Thank you for the article link - I'm reading as fast as I can.

I believe you would empty the T-IRAs in order to start doing backdoor Roths each year. The money goes to an empty T-IRA then is immediately converted to a Roth the next day. So your Roth balances grow.

seattlecyclone

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Re: Is a non-deductible IRA any good?
« Reply #6 on: June 29, 2016, 11:35:33 AM »
-Why would I want to fund an Roth IRA if I was over the deductible limit? At that point, don't I have to start keeping an eye on the Roth limits?

For a married couple, you can take a full traditional IRA deduction if you're below $98k MAGI. The phase-out range goes up to $118k. You can make a full Roth IRA contribution all the way up to $184k MAGI. That's a pretty big gap between where you are and where you would need to be before you would hit the Roth contribution limit. The backdoor Roth IRA is only necessary for people above that line. You might get there eventually, but for now you should be fine making direct Roth contributions.

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-How do I determine exactly what my AGI will be? I have used a bunch of calculators in the past, but they all seem to be estimates and not terribly accurate.

It's hard to know exactly until you do your taxes, especially if your income could change before the end of the year due to raises, bonuses, dividends, etc. The best you can do at this point is make an estimate by looking at your previous pay statements and trying to guess how much money will be coming in for the rest of the year. If you don't want to mess around with recharacterizations, you'll want to guess on the high side for this purpose.

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-How do I determine how much I am eligible to deduct exactly? The IRS site states that a portion can be deducted, but I don't see where they list exactly how much.

It's a linear phaseout between the full deduction limit and the top of the phaseout range. At $98k you can make a full contribution, at $118k you can make no contribution, halfway between ($108k) you can make a half-sized contribution, and so on.

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-I sort of get the pipeline conversion. However, I dismissed it initially because my husband and I are probably never going to be very good mustachians with $15k expenses. So I wasn't sure if it made much of a difference whether we converted to Roth and paid high taxes, or just saved directly in the taxable account and paid high taxes. Unlike many people here, math is not my best friend.

Your exact expense level isn't the most important thing for the Roth pipeline to make sense. If your tax bracket is higher now than it will be in retirement, then you should be making pre-tax retirement account contributions as much as possible. The Roth pipeline is just how you get that money out when you retire, paying tax at a lower rate on it than you would pay now if you put it in a taxable account instead.

rockstache

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Re: Is a non-deductible IRA any good?
« Reply #7 on: June 29, 2016, 01:20:05 PM »
This is all really good stuff, thank you so much for taking the time to answer my questions in such detail.

I am thinking now that if my two options for next year are: contribute to the tIRA but be really careful not to exceed the deductible level and track everything, OR just contribute to the Roth IRA (since I don't think our MAGI will probably ever reach the limit for that), the better option is just switch to using the Roth altogether beginning next year. I will definitely need to do some more very detailed reading to be sure.

I love all of the blog posts and comments on blog posts (Mad Fientist, JLCollins, Root of Good etc), about minimizing taxes, but sometimes I feel like they want to summarize and make it sound easy so you will want to do it. Which...I suppose it is easy if you have a good,working knowledge of the tax code. I kind of wish someone would write a detailed one for dummies step by step, including where (and how) to store the necessary records. If I were to be audited (or even mildly questioned) about this stuff by the IRS, I would be in a total panic unless I knew exactly where to point them and why.

dandarc

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Re: Is a non-deductible IRA any good?
« Reply #8 on: June 29, 2016, 01:34:41 PM »
What we do is this in this scenario:

1.  Front-load our workplace retirement to the extent practical (in our case a 457b for her and a solo-401K for me).  Maxing these types of accounts also lowers your MAGI for determining your IRA deduction / Roth IRA contribution eligibility, so good to do this first.
2.  After that, contribute maximum to 2 Roth IRAs (we expect to be eligible for Roth but not necessarily deduction on traditional, so our "best-guess" is Roth).
3.  Come tax-time, do a draft with full traditional-IRAs in TurboTax - it tells us how much is deductible.
4.  Call Vanguard, recharacterize the amount indicated in step 3 to traditional.  Takes 5-10 minutes for each account.
5.  Update Turbo Tax to jive with step 4 and show our real Roth / Traditional split.

It does add some hassle at tax-time, but not that much - maybe 10-20 extra minutes in TurboTax and another 10-20 on the phone with Vanguard.

We don't think it is very likely we'll need to do backdoor-Roth contributions, but if we find ourselves there, we'll work that into our plan.  Couple of gotchas there regarding existing traditional IRA money, so some thought needs to be put into your plan if you go that route anyway.

Sailor Sam

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Re: Is a non-deductible IRA any good?
« Reply #9 on: June 29, 2016, 02:08:30 PM »
^I follow dandarc's pipeline, as well.

A slightly easier approach would be to wait to fund your 201x ROTH in 201x+1, after you've done your taxes and know your MAGI. But you do lose that sweet, sweet dollar cost averaging.

rockstache

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Re: Is a non-deductible IRA any good?
« Reply #10 on: July 01, 2016, 07:48:17 AM »
What we do is this in this scenario:

1.  Front-load our workplace retirement to the extent practical (in our case a 457b for her and a solo-401K for me).  Maxing these types of accounts also lowers your MAGI for determining your IRA deduction / Roth IRA contribution eligibility, so good to do this first.
2.  After that, contribute maximum to 2 Roth IRAs (we expect to be eligible for Roth but not necessarily deduction on traditional, so our "best-guess" is Roth).
3.  Come tax-time, do a draft with full traditional-IRAs in TurboTax - it tells us how much is deductible.
4.  Call Vanguard, recharacterize the amount indicated in step 3 to traditional.  Takes 5-10 minutes for each account.
5.  Update Turbo Tax to jive with step 4 and show our real Roth / Traditional split.

It does add some hassle at tax-time, but not that much - maybe 10-20 extra minutes in TurboTax and another 10-20 on the phone with Vanguard.

We don't think it is very likely we'll need to do backdoor-Roth contributions, but if we find ourselves there, we'll work that into our plan.  Couple of gotchas there regarding existing traditional IRA money, so some thought needs to be put into your plan if you go that route anyway.

I love that you broke that down for me step by step. Thank you! This actually sounds very doable.