The potential availability of a current year tax deduction for contributions made to a traditional IRA is perhaps its most appealing feature for many taxpayers. After all, getting a tax deduction for your saving activities is like an instant return on investment. For example, if you make a $5,000 contribution that nets you a full $5,000 deduction on your tax return, and your effective tax rate is 25%, then you’re effectively paying just $3,750 for that $5,000 deposit.
But there are situations where that deduction may not be available. In many situations, making a contribution to a non-deductible self-directed IRA will still be in your best long-term financial interests.
- When You’re Not Eligible to Make Contributions to a Deductible IRA.
Not everyone is eligible to make a tax-deductible contribution to an IRA. For example, if you’re covered by a retirement plan at work (such as a 401(k)), then you are only eligible to make fully tax deductible contributions if your modified adjusted gross income is $61,000 or less and you file as a single taxpayer. (A partial deduction is available if your income is between $61,000 and $71,000.) Couples who file jointly must have a modified AGI of $90,000 or less (with a partial deduction available for incomes between $90,000 and $118,000).
Despite not being able to get the deduction, the funds you deposit into a self-directed IRA will grow on a tax-advantaged basis. In the case of a Roth self-directed IRA, you’ll never pay taxes on distributions that you take from your account once you reach age 59½.
- When The Value of the Contribution Deduction is Low.
Even if you are eligible to make a deductible contribution to a traditional self-directed IRA, it’s important to determine exactly what the value of the deduction will be, and weigh that against the value you could receive in the longer term by making a contribution to a Roth account. For example, taxpayers with relatively low modified AGIs – which may be due to having a large number of other deductions available, and/or a lower income – might not find an IRA deduction to be particularly valuable.
Keep in mind that the IRA contribution deduction is a deduction, not a credit, so the lower your modified AGI, the lower the effective value of that deduction will be. for example, if a $5,000 contribution only yields you a tax bill that’s a few hundred dollars lower, then you should probably consider making that year’s contribution to a Roth self-directed IRA instead in order to receive tax free distributions once you hit retirement.
- When You Have Other Sources of Retirement Income.
The rules on required minimum distributions are not given enough attention by many retirement savers. these rules require that, once you reach age 70½, you must begin taking distributions each year from your traditional IRA.this means that not only will your account balance not be able to grow as much, you’ll be hit with a tax bill on those distributions.
In contrast, a Roth self-directed IRA is not subject to those rules. Therefore, if you anticipate having a large nest egg and/or various other sources of income during retirement, your best long-term financial bet may be to prioritize non-deductible contributions to your Roth account rather than trying to make deductible contributions to a traditional account.