Nondeductible Traditional IRA Contribution -- does it make sense?

[shawndoggy]

My wife and I max out our tax sheltered savings options through work, and make too much to do deductible traditional IRA contributions or Roth contributions.  We both have high 5 figures in traditional IRAs, so the backdoor roth is unappealing because of the "bonus" tax hit.

So my question: where the deductible traditional IRA and Roth are is no longer options, does it still make sense to make a nondeductible contribution to a traditional IRA? 

My simpleton's brain says yes because the income is still growing tax deferred, but maybe I'm overlooking something.

[erutio]

I would look into if you can roll your TIRA balances into your work 401k or 403b.  Once your TIRA pre-tax balances are back to zero, you are free to do the backdoor Roth pathway without incurring a taxable event.

[shawndoggy]

I would look into if you can roll your TIRA balances into your work 401k or 403b.  Once your TIRA pre-tax balances are back to zero, you are free to do the backdoor Roth pathway without incurring a taxable event.

interesting suggestion.  my employer recently changed investment providers and this now looks like it could be a viable option.

[johnny847]

With a Traditional IRA, it's only "tax-deferred" if you get to put pre-tax money in, typically by taking the deduction at tax time. In this case, you'd be putting post-tax money in. Then when you'd take it out... you'd pay tax on it! So no, unless there's some trick to get it out tax-free later, I don't think it would be worth it. Probably better to put it in a regular taxable investment account.

No, you pay taxes on the gains only, not the entire withdrawal amount. You track the basis of your tIRA on some I forget the number of.

You do avoid paying taxes on your dividends when you're issued them. You would eventually pay taxes on the gains from your dividends when you withdraw them, but at your retirement tax brackets.

The problem is that any taxes on gains are always applied at your normal income tax rates, not your long term capital gains rate, which is always lower. Because of this, I'd still avoid making non deductible contributions to a tIRA unless, as erutio mentioned, you can rollover your tIRA into a 401k that has reasonable fees so that you can use the backdoor

[wudged]

With a Traditional IRA, it's only "tax-deferred" if you get to put pre-tax money in, typically by taking the deduction at tax time. In this case, you'd be putting post-tax money in. Then when you'd take it out... you'd pay tax on it! So no, unless there's some trick to get it out tax-free later, I don't think it would be worth it. Probably better to put it in a regular taxable investment account.

No, you pay taxes on the gains only, not the entire withdrawal amount. You track the basis of your tIRA on some I forget the number of.

You do avoid paying taxes on your dividends when you're issued them. You would eventually pay taxes on the gains from your dividends when you withdraw them, but at your retirement tax brackets.

The problem is that any taxes on gains are always applied at your normal income tax rates, not your long term capital gains rate, which is always lower. Because of this, I'd still avoid making non deductible contributions to a tIRA unless, as erutio mentioned, you can rollover your tIRA into a 401k that has reasonable fees so that you can use the backdoor

If I'm understanding what you're saying correctly, it's that if I put $180,000 in my tIRA over 10 years, and then hit 59.5 and start pulling that money out, the first $180,000 would not be taxed. I do not think that is correct.

From my understanding, it is prorated.  Assume you gained 10%, your balance would be 198,000.  You would be taxed on (1 - (180,000 / 198,000)) * whatever amount you withdraw.

Let's say you withdraw 10,000, you would owe tax on $909.09 while the remaining 9090.91 would be tax free.

[johnny847]

With a Traditional IRA, it's only "tax-deferred" if you get to put pre-tax money in, typically by taking the deduction at tax time. In this case, you'd be putting post-tax money in. Then when you'd take it out... you'd pay tax on it! So no, unless there's some trick to get it out tax-free later, I don't think it would be worth it. Probably better to put it in a regular taxable investment account.

No, you pay taxes on the gains only, not the entire withdrawal amount. You track the basis of your tIRA on some I forget the number of.

You do avoid paying taxes on your dividends when you're issued them. You would eventually pay taxes on the gains from your dividends when you withdraw them, but at your retirement tax brackets.

The problem is that any taxes on gains are always applied at your normal income tax rates, not your long term capital gains rate, which is always lower. Because of this, I'd still avoid making non deductible contributions to a tIRA unless, as erutio mentioned, you can rollover your tIRA into a 401k that has reasonable fees so that you can use the backdoor

If I'm understanding what you're saying correctly, it's that if I put $180,000 in my tIRA over 10 years, and then hit 59.5 and start pulling that money out, the first $180,000 would not be taxed. I do not think that is correct.

It is correct for non-deductible tIRA contributions, which is what we've been talking about for this entire thread.

[koralcem]

Recently became aware of non-deductible tIRA contributions, read about them, read through this thread as well, but still trying to make sense of things. Forgive me for possible stupid questions here.

1) I'd like to ask the complementary version of the OP question. Does it ever make sense to even think about a non-deductible tIRA contribution as long as your income allows you to contribute to a Roth IRA? For instance, is the following logic correct?

If your income level is:
- Between $0 and the amount where deductible contributions gets phased out: contribute to a tIRA (deductible) or Roth IRA depending on your current and post-FIRE expected tax brackets.
- Between not being allowed a deductible contribution and not being allowed a Roth contribution: contribute to a Roth. If you can't get the deduction anyway, might as well save on taxes later.
- Above the Roth contribution limit: Then, and only then, is where this thread comes in, right?

2) Can someone elaborate on erutio's point about about rolling the tIRA into a 401k before doing the backdoor roth? I don't follow how one can not incur a taxable event like that. At the moment of the roth conversion the converted amount will still be considered income, no? How does going through a 401k change things?

[johnny847]

1) I'd like to ask the complementary version of the OP question. Does it ever make sense to even think about a non-deductible tIRA contribution as long as your income allows you to contribute to a Roth IRA? For instance, is the following logic correct?

If your income level is:
- Between $0 and the amount where deductible contributions gets phased out: contribute to a tIRA (deductible) or Roth IRA depending on your current and post-FIRE expected tax brackets.
- Between not being allowed a deductible contribution and not being allowed a Roth contribution: contribute to a Roth. If you can't get the deduction anyway, might as well save on taxes later.
- Above the Roth contribution limit: Then, and only then, is where this thread comes in, right?

Yup

2) Can someone elaborate on erutio's point about about rolling the tIRA into a 401k before doing the backdoor roth? I don't follow how one can not incur a taxable event like that. At the moment of the roth conversion the converted amount will still be considered income, no? How does going through a 401k change things?

Rolling the tIRA into a 401k before doing the backdoor Roth is to avoid the pro rata rule.

Say you had a tIRA with a $20k that were all from deductible contributions. Let's also say you make too much for a direct Roth contribution and you want to put $5k into a Roth via the backdoor (I know the contribution limit is $5500 but I just want easy numbers).

If you don't rollover the tIRA into the 401k, you're going to run into a problem. When you put $5k into a tIRA as a non-deductible contribution and then convert $5k to the Roth IRA, you're going to have 80% of that ($20k out of $25k = 80%), i.e. $4k, added as taxable income for that year. It doesn't matter if you opened an IRA at a different brokerage for that $5k contribution - the IRS considers all of your IRAs as one big IRA when using the pro rata rule.

If instead you rollover the tIRA to your 401k, now the entire tIRA is made from nondeductible contributions and has a basis. When you convert this into a Roth IRA, you don't have any tax liability. The $5k conversion does not count as income. Remember, you never got a deduction for this, so it's not pre-tax money that you need to be taxed on: it's already post tax money. They don't tax it again when you convert it to the Roth IRA.

Did that make sense?

[koralcem]

That did make a lot of sense. Thank you so much for the explanation johnny847.

That also brings up an interesting point though. If you make too much for a Roth contribution and can, somehow, ever manage to reset your tIRA balances, you essentially have a perpetual Roth backdoor available to you. Once reset, is there a reason why you couldn't just make a $5500 non-deductible contribution to a fresh tIRA, immediately convert it to a Roth, and then repeat the same process every year going forward?

At that point why not just remove the cap on the Roth contributions? Is the underlying assumption that most people can't get into this state to begin with, because they won't have the opportunity to reset tIRA balances?

[FINate]

FYI - If you make nondeductible IRA contributions you need to file Form 8606 with your taxes for the year the contribution was made. This ensures that nondeductible (ie already taxed) contributions are not taxed a second time when withdrawn:

https://turbotax.intuit.com/tax-tools/tax-tips/IRS-Tax-Forms/What-is-IRS-Form-8606--Nondeductible-IRAs/INF28070.html

Any money you contribute to a traditional IRA that you do not deduct on your tax return is a “nondeductible contribution.” You still must report these contributions on your return, and you use Form 8606 to do so.

Reporting them saves you money down the road. That’s because no individual’s money is supposed to be subject to federal income tax twice. Form 8606 gets it “on the record” that a portion of the money in your IRA has already been taxed. Later on, when you take distributions, a portion of the money you get back will not be subject to income tax.

[johnny847]

That did make a lot of sense. Thank you so much for the explanation johnny847.

That also brings up an interesting point though. If you make too much for a Roth contribution and can, somehow, ever manage to reset your tIRA balances, you essentially have a perpetual Roth backdoor available to you. Once reset, is there a reason why you couldn't just make a $5500 non-deductible contribution to a fresh tIRA, immediately convert it to a Roth, and then repeat the same process every year going forward?

Once you do the reset, that's correct - just keep doing the backdoor every year as long as it still makes sense for you tax wise (as in your income is still high enough for you to be in this position).

At that point why not just remove the cap on the Roth contributions? Is the underlying assumption that most people can't get into this state to begin with, because they won't have the opportunity to reset tIRA balances?

Nobody ever said Congress makes laws that always makes sense ;)

All kidding aside, two things
1) Not everyone can do that reset though. Some 401k's just don't allow incoming tIRA rollovers.
2) It may have been an oversight when Congress passed the law. Apparently there are talks about closing this backdoor - a way of raising taxes without actually having to raise taxes.


Oh yeah, just a terminology thing that I don't think you used incorrectly, but I've seen other people do:
There is no such thing as a deductible tIRA or a non deductible tIRA. There's only deductible and non deductible contributions. If you make non deductible contributions to a tIRA, your tIRA now has a basis.


And yes, make sure you file that Form 8606!

[A440]

If you can't roll your previous IRA contributions into a work 401k, you could consider starting a solo 401k for this purpose.  You would have to have some self-employment income to get started.   

[johnny847]

If you can't roll your previous IRA contributions into a work 401k, you could consider starting a solo 401k for this purpose.  You would have to have some self-employment income to get started.

Yup. Just don't open it at Vanguard, as they don't allowing incoming tIRA rollovers for their solo 401k's (at least, last time I checked). Nor do they have admiral shares available in them.