Many individuals first become interested in opening an Individual Retirement Account when they learn that in some situations their annual contributions are deductible on their current year’s tax return. It’s important to understand that the term “deductible IRA” refers to traditional IRAs, as opposed to the Roth IRA structure. But it’s also important to know that the actual deductibility will depend on a number of factors, and that not all contributions to a traditional IRA are deductible.
The concept of a “non-deductible IRA” therefore refers to Roth IRAs and sometimes to traditional IRAs. Here are some reasons why, despite the non-deductibility of contributions to those accounts, they can still be an extremely valuable part of your retirement planning.
To Save on Taxes Later in Life
If you have a Roth IRA, the withdrawals you make in retirement will not be subject to federal income tax. Since the majority of your IRA account balance will likely be comprised of earnings, the total value of tax savings down the road will far exceed the value you’d obtain from having your contributions be tax deductible.
To Avoid the Rules on Required Minimum Distributions
Once you reach age 70½, you must begin taking annual distributions from a traditional IRA, and these distributions must be above a certain minimum amount (which varies with your age and account balance). This will not only reduce the amount of savings you have growing on a tax deferred basis, but also subject you to current year taxation on the amount of the distributions. Roth IRAs are not subject to these rules, so some people are willing to give up current year deductibility by making contributions to a Roth account.
Estate Planning Advantages
The rules on passing on Roth IRAs are much more flexible and advantageous; so many individuals choose that account structure in order to help them better achieve their estate planning goals.
If You’re Covered by a 401(k) Plan at Work
All of the advantages of making non-deductible contributions highlighted above apply to Roth IRAs. But there are also situations where you might want to make non-deductible contributions to a traditional IRA as well.
For example, some individuals choose to participate in an employer sponsored retirement program such as a 401(k). Participation in a 401(k) plan won’t affect their ability to contribute to an IRA (either a Roth or a traditional account), but it will impact their ability to take a tax deduction for a contribution to a traditional account. For 2013, single taxpayer who’s covered by a 401(k) can’t take a deduction for their traditional IRA contribution if their modified adjusted gross income is $69,000 or more. And if that same individual’s income is over $127,000 they’re not permitted to contribute to a Roth IRA
This means that in order to make a contribution to their IRA account (which is always a good idea from a long term perspective), that person will need to make a non-deductible contribution to a traditional account.