For many individuals, their tax planning strategy — to the extent they have one at all — revolves around trying to maximize the deductions they can take each year on their returns. The personal exemption, deductions for dependents, and the home mortgage interest deduction are all extremely popular deductions to personal income.
Many individuals also try to take advantage of the deduction that’s available for contributions to a traditional IRA in certain circumstances. (A similar economic outcome occurs for contributions to a 401(k), because those contributions are generally made with pre-tax earnings via payroll deductions.)
But while the value of a deductible contribution to a self-directed IRA can be significant, it shouldn’t be your only consideration when deciding whether or not to make a contribution to your retirement account, and what type of account to choose to receive those contributions.
Remember that self-directed IRAs come in two basic types. There are traditional self-directed IRAs, to which contributions are sometimes deductible, and Roth self-directed IRAs, to which contributions are never tax deductible.
For example, let’s say that you are covered by a retirement plan at work (such as a 401(k)), and that your modified adjusted gross income exceeds the IRS limits ($71,000 for the 2015 tax year). You’re eligible to contribute to a traditional self-directed IRA, but your contributions won’t be deductible. If your modified adjusted gross income is less than $116,000, then you’ll also be eligible to contribute to a Roth self-directed IRA, but again, your contributions won’t be deductible.
All other factors being equal, your best bet is likely to be making the contributions to a Roth account. The primary advantage that a Roth self-directed IRA has over a traditional self-directed IRA is that all distributions from the account will be tax-free during retirement. This can be a significant source of additional funds for your living expenses during retirement. There are numerous other benefits to a Roth account, including not being subject to the rules on required minimum distributions.
But even making non-deductible contributions to a traditional account can provide you with significant benefits. Investments within a traditional IRA grow on a tax-deferred basis, and no tax will be due until you take a distribution from your account. This means that your non-deductible contributions still have the opportunity to grow for years or even decades without you having to pay tax on the gains or the income from those investments.
Note that it’s not at all uncommon, and entirely permissible under the IRS regulations, to maintain multiple IRAs. If you choose, this means that you can set up a traditional self-directed IRA to which you can make deductible contributions in the years that you’re eligible to do so, and also have a Roth self-directed IRA that you can contribute to when you’re not eligible to make those deductible contributions.