Is a non-deductible Traditional IRA contribution a good or bad idea?
There have been several changes over the past five to six years that make non-deductible Traditional IRA contributions less attractive for the vast majority of individuals.
In 2011, singles with an Adjusted Gross Income (AGI) of less than $56,000 and couples filing jointly with AGI of less than $90,000 are eligible for IRA contribution deduction. Singles earning up to $66,000 and couples earning up to $110,000 are eligible for partial contribution deduction.
In years past, it made sense for most people to continue to make IRA contributions, even if their income was too high to qualify for an IRA contribution deduction, but the tax law changes in 2003 and 2006 muddied the waters of this question a little.
In 2003, the capital gains tax rate was reduced to 15% or 5% for long-term gains (assets held for more than one year), depending on your income. With the reduction of capital gains rates, it could make sense to save money to your taxable accounts, hold assets for at least one year, and pay the capital gains rate versus deferring your gains in an IRA and pay ordinary income rates when you pull money from the IRA. However, if the capital gains rate increases in the future, non-deductible IRA contributions may become more attractive.
If you are likely to buy a fund or stock and hold it for many years, you are probably better off avoiding an IRA and investing the money in a taxable account. With dividends and capital gains now both taxed at a maximum of 15%, this approach makes more sense. Whenever you eventually sell a stock or fund held in a taxable account, you will pay capital gains taxes on the gain.
If you are likely to trade the account regularly and make frequent changes to the stocks or bonds in the account, a non-deductible IRA contribution still makes sense. The IRA provides the benefit of avoiding taxes on frequently realized capital gains. This benefit makes the IRA desirable, even if you do not receive tax benefits for the contributions. This scenario is a strong argument to make the IRA contribution, as the savings over a long period of time can be substantial.
Another item that should be considered before making a non-deductible IRA contribution is the mix of accounts you hold. If most of your assets are in taxable accounts, make the IRA contribution, so that if future tax laws benefit tax-deferred accounts more than today, you will have some assets that receive the benefits. If most of your assets are in retirement accounts, such as 401(k) plans or IRA accounts, consider skipping the IRA contribution this year and add to taxable accounts instead.
Beginning in 2010, taxpayers with Adjusted Gross Income over $100,000 are allowed to convert a Traditional IRA to a Roth IRA. While the income limits for Roth IRA contributions still apply, anyone can convert to a Roth IRA. The income limits for a Roth IRA Contribution in 2011 remain as follows:
Single Tax Payers can contribute the full amount to a Roth IRA if their income is less than $107,000 and less than $169,000 for Married Filing jointly. The amount you can contribute to a Roth phases out between $107,000 to $122,000 for singles and $169,000 to $179,000 for married filing jointly.
One strategy that makes a non-deductible IRA contribution attractive is that after you make the contribution, you can convert the IRA account to a Roth IRA. Therefore, every year you make an IRA contribution, you then convert the amount contributed before the end of the year. You should make sure you keep track of the non-deductible IRA contributions made before the conversion, so you will not have to pay taxes on the amount converted. If you already have a Traditional IRA account, you will want to make sure you are aware of the conversion specifics before you move the money to a Roth IRA. You will have to consider all your IRA accounts when calculating the amount owed in taxes. The tax rule states conversions are done on a pro-rata basis. For example, if you have an existing IRA (with pre-tax money) valued at $100,000 and an IRA with non-deductible contributions valued at $25,000, you will owe tax on $20,000 because the pro-rata share of your non-deductible IRA is only $5,000.
All these reasons should be considered, when trying to decide if you want to make a non-deductible IRA contribution. It is important that you save money and invest it wisely, even if you do not make an IRA contribution. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].