High-income individuals can be denied the option of contributing to these accounts because of Roth IRA income limits. However, they can still divert money into a Roth IRA indirectly by first making nondeductible IRA contributions to a traditional IRA with after-tax dollars.
Deductible vs. Nondeductible IRA Contributions
Nondeductible contributions to a traditional IRA are subject to the same contribution limits as those that can be tax deducted. You can contribute up to $6,000 tax-free in 2021 and 2022, or $7,000 if you’re age 50 or older. The difference is in how the contribution is treated tax-wise. Contributions to traditional IRAs are made with before-tax dollars. You can claim a tax deduction for them at the time you make them. You don’t pay taxes on that money until you withdraw the funds. Nondeductible IRA contributions use after-tax dollars. You can’t deduct them on your tax return. They’re not taxed when you withdraw the money. Roth IRA contributions are also made with after-tax dollars. You don’t get a tax deduction for them, but you can take qualified distributions from these accounts without paying further income taxes. You must file Form 8606 to report nondeductible IRA contributions. These form your “basis” in the assets. You can make both deductible and nondeductible contributions to a traditional IRA, but only your basis is tax-free. The deductible portion of the distribution is still taxable.
Roth IRA Income Limits
Nondeductible IRAs can be useful for those whose adjusted gross incomes (AGIs) are too high to make Roth IRA contributions. For example, your ability to contribute to a Roth starts to phase out at an income level of $125,000 in 2021 if you’re single. This phase-out limit increases to $129,000 in 2022. Roth contributions aren’t allowed at all for singles with AGIs of $140,000 or more in 2021 ($144,000 in 2022). You might consider making nondeductible contributions to your traditional IRA if you’re one of these investors. You can then convert them into Roth IRA assets. Converting nondeductible IRA funds to a Roth is sometimes called a “backdoor Roth IRA” strategy.
Converting Nondeductible Contributions to a Roth IRA
You can make a nondeductible IRA contribution each year, then convert it to a Roth IRA using the backdoor approach. You’ll pay taxes on any converted amount that’s above your basis at the time you convert. Your basis must be calculated using a pro-rata, or proportional, formula if you have other IRA accounts. For example, suppose you have $12,000 in a traditional IRA. You make a $6,000 nondeductible contribution to a separate IRA account. You now have a total of $18,000 in two IRAs. One-third of that amount is nondeductible, and the other two-thirds are deductible. You can’t convert just the nondeductible IRA portion. The IRS looks at all your IRA accounts combined and calculates your basis proportionally. So, one-third of the converted amount (about $2,000) would be considered the basis, and the other two-thirds (about $4,000) would be considered taxable income in the year of the conversion if you were to convert just $6,000.
Avoid the Pro-Rata Basis Rule
The pro-rata basis rule doesn’t apply if you have all your other retirement money in a 401(k) plan. You could then make a nondeductible IRA contribution each year. The full amount of the conversion would be the basis if you were to immediately convert it to a Roth. For example, let’s say you have $300,000 in a 401(k) plan and nothing in an IRA. You can fund the IRA as a nondeductible contribution and convert it to a Roth. The converted amount isn’t taxable income, because it’s all basis. It was made with after-tax dollars. You can also roll traditional IRA balances back into an employer plan such as a 401(k), leaving only your nondeductible IRA balances outside the plan. You could then use the backdoor Roth-conversion strategy in the future without worrying about accounting for the pro-rata basis.
Tax Reporting
The IRS asks for year-end account balances as of the year you’re filing Form 8606 and your tax return. You would have to roll traditional IRA contributions into a 401(k) plan before year’s end to use the conversion strategy for that year. You would be free to convert only the balance of your nondeductible IRA contributions to a Roth through the backdoor strategy if you have no funds remaining at year’s end. That would include money in traditional IRAs, SEPs, or SIMPLE IRAs if they were rolled over into a qualified plan.
Common IRA Mistakes
The most common mistake made with nondeductible IRAs is forgetting to complete Form 8606 with your tax return. However, you can report it in arrears if you’ve made nondeductible IRA contributions but failed to report your basis. Another common mistake is thinking that you can convert only your nondeductible IRA contributions to a Roth. You have to look at the total of all your IRA accounts when you’re determining the amount of tax owed when you convert.
