Q: When making deductible and nondeductible contributions to a traditional IRA, must I use different investments? For example, does a $3,500 deductible contribution have to go to Fund A while a $2,000 nondeductible investment goes to Fund B? — Michael
A: First, a little background: If you’re under 70 1/2 and have earned income, you can contribute money to a traditional IRA. Based on how much you earn and your access to a work-sponsored retirement plan, you may be eligible to deduct that money from your taxes upfront. If you don’t qualify, you can still participate — by contributing after-tax dollars and having that money grow tax-deferred over time.
A nondeductible traditional IRA is not to be confused with a Roth IRA. In a Roth, investments are also made with after-tax dollars. But when it comes time to withdraw Roth IRA funds in retirement, the money comes out tax free. With a nondeductible traditional IRA, your gains will be taxed as ordinary income when you tap the account in retirement.
Now back to the question. You are not required to segregate nondeductible and deductible contributions to investments within an IRA. Even if you did, it would not matter, says Pete Lang, founder and president of Lang Capital in Hilton Head, S.C.
“It works like pouring cream into coffee,” says Lang, who was a CPA and tax attorney before starting his wealth management firm. “Once you mix the two there is no going back.”
Lang recommends a different approach: Open separate IRA accounts, one for your deductible contributions and one for your non-deductible contributions. (Be sure to file a form 8606 to make sure that you aren’t taxed a second time down the road.)
Doing this will make it easier to convert your nondeductible account to a Roth IRA or move that money into a tax-deferred account down the road, at which point you might be able to deduct those contributions.
If you do this with a traditional IRA of deductible contributions, you’ll pay a tax on everything you roll over or convert. If you have a dedicated non-deductible account, you only owe taxes on earnings. And if you have both: You’ll need to prorate the contributions that were deducted and not deducted and then calculate the tax accordingly.
Why would you use a non-deductible IRA? Two reasons. The first is that you earn too much to make deductible contributions but you still want the benefit of tax-deferred growth.
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If have access to an employer-sponsored retirement plan, IRA deductions start to phase out at $61,000 modified adjusted gross income if you are single and $98,000 for couples filing jointly. After $71,000 and $118,000 respectively you cannot take a deduction. There are no income caps for single filers who don’t have access to a company retirement plan; deductions for married couples filing jointly begin to phase out at $184,000 and disappear at $194,000.
A second reason is to take advantage of the long-term tax benefits of a Roth but earn too much to contribute. (Benefits phase out at $132,000 if you’re single or $194,000 if you’re married filing jointly for 2016).
As an alternative, you can get into a Roth through the back door – by contributing to a non-deductible IRA and converting it to Roth. While you lose the immediate deduction you stand to save on taxes down the road.