Tax deductibility of annual contributions has always been one of the biggest selling points of traditional IRAs, self-directed IRAs included. This tax break is often the deciding factor that gets some individuals to adjust their budgets or forego discretionary spending in order to save for their own retirement future.
But the Roth IRA, even though contributions to it can never be deducted, can still be extremely valuable (and for some individuals, even more valuable). Even non-deductible contributions to a traditional account can provide you with significant long-term tax savings. If you’re faced with the prospect of having to make a non-deductible IRA contribution this year, here are some reasons to go ahead and do so.
Tax-Free or Tax-Deferred Investment Growth. It’s important to understand that while there’s unmistakable value to the current year tax break you might get from a deductible contribution, you may get greater value from the tax-free investment growth that a Roth IRA can provide.
Consider that even though you don’t have to pay income tax on the investment gains you realize within a traditional self-directed IRA, you will eventually have to pay taxes on those gains when you take a distribution of those funds. And that total tax bill can be significant, given how much your account can grow over time.
In contrast, distributions that are taken from a Roth IRA never incur a tax liability, provided you’ve reached full retirement age. This is a unique situation in the tax law – never having to pay taxes on investment gains – and the financial benefit can be quite substantial.
To Maximize Your Retirement Savings. The more money you can accumulate for retirement, the better. When you make a non-deductible contribution to a self-directed IRA (whether it’s a Roth or even to a traditional account), you’ll still be able to invest and grow that money on a tax-deferred (in the case of a traditional account) or tax-free (in the case of a Roth account) basis.
Just remember that if you make both deductible and non-deductible contributions to a single traditional account you’ll face some potentially challenging record keeping obligations in order to determine what portions of your future distributions are subject to tax, and which are not. Some retirement savers choose to get around this administrative headache by simply having a Roth account as well as a traditional self-directed IRA.
So, when are you likely to be faced with having to make non-deductible contributions? You may find that you’re ineligible for the tax deduction if your income is too high in a particular year, and that income threshold will be lower if you participate in a 401(k) through your employer. Whatever the reason, the best way to build your retirement nest egg is to save the maximum amount you can to your self-directed IRA every single year, whether you can take a tax deduction for the contribution or not.