Can I Still Contribute to an IRA – Even if I Don’t Get a Tax Break?

Can I Still Contribute to an IRA – Even if I Don’t Get a Tax Break?

Let’s start by reviewing the basics about traditional IRAcontributions, and about the income limits that apply to them.

First, it’s important to understand that, unlike Roth IRAs, the IRS income limits for traditional IRAs apply only to the tax deductibility of traditional IRA contributions.

BUT YOU CAN STILL MAKE CONTRIBUTIONS EVEN IF YOU EXCEED THE INCOME LIMITS.

That is the answer to the main question.

You can contribute up to $5,500 per year, or up to $6,500 per year if you are age 50 or older. What’s more, if your spouse is not employed outside the home and does not have a retirement plan, you can also set up a spousal IRA. That will enable you to make matching contributions to a traditional IRA for him or her, even though he/she has no income.

But let’s get back to those income limits…

The 2017 income limits for tax deductible contributions to a traditional IRA if you ARE covered by an employer retirement plan are:

  • Married filing jointly – fully deductible up to $99,000; phased out between $99,000 and $119,000; not permitted at $119,000 and above
  • Single or head of household – fully deductible up to $62,000; phased out between $62,000 and $72,000; not permitted at $72,000 and above
  • Married filing separately – deduction phased out between 0 and $10,000; not permitted at $10,000 and above

If you are not covered by an employer retirement plan, but your spouse is, you can take a deduction for a traditional IRA up to the following income limits:

  • Married filing jointly – fully deductible up to $186,000; phased out between $186,000 and $196,000; not permitted at $196,000 and above
  • Married filing separately – deduction phased out between 0 and $10,000; not permitted at $10,000 and above

ONCE AGAIN, YOU CAN STILL MAKE A CONTRIBUTION TO A TRADITIONAL IRA EVEN IF YOU EXCEED THESE INCOME LEVELS.

The contribution however will not be tax deductible. But that doesn’t mean you shouldn’t make a contribution anyway.

In fact, it’s an excellent strategy for a number of reasons…

Retirement Investment Diversification

Having an IRA, in addition to an employer-sponsored plan, is an excellent way to diversify your retirement investments. At a minimum, it will enable you to have more than one retirement plan, which should increase the types of investments that you have.

This is especially important since many employer plans limit your investment options. For example, they may give you a choice between a handful of mutual funds as well as company stock.

But with a self-directed IRA, you can literally have unlimited investment options. The IRA will give you the ability to invest in assets that you cannot hold in your employer plan.

Tax Diversification in Retirement

A nondeductible IRA can provide you with a certain amount of tax-free income in retirement. The investment income that you earn in plan will be tax-deferred, and will therefore be taxable when you begin taking distributions. But since your contributions were not tax-deductible, they will represent tax-free distributions in retirement.

For example, let’s say that you contribute $5,500 to a nondeductible IRA each year for 10 years. At the end of that time, the account is worth $100,000, comprised of $55,000 in contributions, and $45,000 in investment income.

If you were to withdraw $10,000 per year in retirement, $4,500 would be taxable income, but $5,500 – which represents your pro rata nondeductible contributions – will be tax-free.

That strategy will provide you with at least some income in retirement that will not be taxable. That’s tax diversification in retirement.

Making Your Retirement Portfolio Even Bigger

You can save up to $18,000 per year in a 401(k) plan. But if you also save an additional $5,500 in an IRA, you’ll have $23,500 going toward retirement each year. If you are in a position that you can afford to make such contributions, it can really supercharge your retirement planning. It might even open up the prospect of early retirement.

Looking at it from another direction, the strategy also offers the opportunity to increase retirement savings if you are over 50 and don’t have much saved. That’s because both 401(k)s and IRAs have a “catch-up” provision. At 50 or older, 401(k) contributions can be as high as $24,000 per year. IRA contributions can be as high as $6,500.

If you are 50 or older, he can save up to $30,500 per year – $24,000 + $6,500 – toward his retirement. That kind of savings can build up a retirement plan in no time at all.

Setting the Stage for a Lower Tax Roth IRA Conversion

This is another underappreciated reason for doing nondeductible contributions to a traditional IRA. Roth IRAs provide an opportunity to have tax-free income in retirement. They are funded with nondeductible contributions, and the earnings accumulate on a tax-deferred basis. But when you turn 59 1/2, and if you have had your Roth IRA for at least five years, you can take distributions of both your contributions and investment earnings completely tax-free.

The tax-free benefit is the reason why so many people do Roth IRA conversions. That’s the process of converting other retirement plans – 401(k)s, 403(b)s, 457s and traditional IRAs – into Roth IRAs. In doing so, you convert other retirement savings that would produce taxable distributions in retirement, to the Roth IRA, which will provide tax-free distributions.

THE DOWNSIDE IS WHEN YOU DO A ROTH CONVERSION, YOU HAVE TO PAY INCOME TAX ON THE AMOUNT OF RETIREMENT SAVINGS THAT HAS BEEN CONVERTED.

But the exception is if you have made after-tax contributions, such as those made to a nondeductible traditional IRA. Since no tax deduction was taken on the contributions, there will be no income tax due on that portion of the conversion.

Let’s take another look at earlier example, of a $100,000 traditional IRA that is comprised of $55,000 in nondeductible contributions, and $45,000 in accumulated investment income.

If you were to do a Roth conversion on that account, only the $45,000 that makes up the accumulated investment portion will be subject to income tax. There’ll be no tax consequences on the $55,000 in nondeductible contributions.

If you were in the 25% federal tax bracket, and you converted $100,000 in retirement assets to a Roth IRA, you’d have to pay $25,000 in federal income tax. But if that plan includes nondeductible contributions of $55,000, the tax bite would be only $11,250 ($45,000 X 25%).

Just as important, if the full $100,000 was taxable, it would probably also push you into a higher tax bracket, resulting in an even larger tax liability. That will be less likely to happen with a traditional IRA which includes nondeductible contributions.

So in a real way, setting up a traditional IRA with nondeductible contributions really sets the stage for a lower tax Roth IRA conversion.

But Hold On – You May Be Able to Do Direct Roth IRA Contributions!

This strategy wasn’t part of Anup’s question, but it may be important for Anup or for other readers who are in this situation. That is, even if you exceed the income limits for deductible traditional IRA contributions, you may still be able to make Roth IRA contributions.

Why?

There is a “window” in the income limits between deductible traditional IRA contributions and Roth IRA contributions.

Consider the following…

The Roth IRA income limits for 2017 are:

  • Married filing jointly – fully allowed up to $186,000; phased out between $186,000 and $196,000; not permitted at $196,000 and above
  • Single, head of household or married filing separately but you DON’T live with your spouse – fully allowed up to $118,000; phased out between $118,000 and $133,000; not permitted at $133,000 and above
  • Married filing separately but you DO live with your spouse – phased out from 0 to $10,000; not permitted at $10,000 and above

Notice if you’re married filing jointly, you can make a Roth IRA contribution up to an income of between $186,000 and $196,000. But you can make a deductible traditional IRA contribution at an income level of only between $99,000 and $119,000, if you’re married filing jointly, and you’re covered by an employer retirement plan.

Do you see where I’m going with this? If your income is higher than $119,000 – and you can no longer make a tax-deductible traditional IRA contribution – you can still make a Roth IRA contribution if your income does not exceed $186,000.

So let’s say Anup is earning $160,000. Since he is covered by a 401(k) plan at work, he can still make a contribution to a traditional IRA, but it won’t be tax-deductible.

HE MAY DECIDE INSTEAD TO MAKE A ROTH IRA CONTRIBUTION.

Why should he do that? Well, for starters, at that income level, neither a contribution to a traditional IRA nor a Roth IRA will be tax-deductible. And both will allow tax-deferred investment income accumulation. But the difference is that with the Roth IRA, a person will be entitled to tax-free withdrawals in retirement.

So if you are in that income limit “middle ground” between a tax-deductible traditional IRA contribution and a Roth IRA contribution, you should make a contribution to the Roth IRA instead.

That will also prevent the need to do a costly Roth IRA conversion later.

Thus this was an excellent question! It gives us a chance to take a look at something that seems simple on the surface, but has a lot of potential for better options when you consider it from all angles!

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