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I'm really confused about my saving situation, despite all of the articles and information I have found online.

  1. My employer offers a Roth 401(k), and I'm contributing up to the maximum employer match every year.
  2. Because of this, I make too much income to deduct a Traditional IRA from my taxes.

Can I still invest $5,500 in a traditional IRA, even though I cannot deduct? If I can, is this a good idea, or should I put my money elsewhere?

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To your question. Yes. What you propose is typically called the back door Roth. You make the (non-deductible) IRA deposit, and soon after, convert to Roth. As long as you have no other existing IRA, the process is simple, and actually a loophole that's still open.

If you have an existing IRA, the conversion may be partially taxed based on untaxed balance. As comments frequently get overlooked, I'm adding @DilipSarwate excellent warning regarding this -

Depending on the value of the existing Traditional IRA and its pre-existing basis, if any, the backdoor Roth conversion might be almost completely taxable. Example: Traditional IRA worth $250K with zero basis. New nondeductible contribution increase value to $255.5K and basis $5.5K. Converting $5.5K into a Roth IRA leaves $250K in the Traditional IRA with basis $5381.60. That is, of that $5500 conversion, only $118.40 was nontaxable and so, not only is the original $5500 taxable income to the OP but he also owes taxes on $5381.60 of that $5.5K conversion.

In short, discussions of backdoor Roth conversions as a great idea should always be tempered with an acknowledgement that it does not work very well if there is any other money in the Traditional IRA. Once that nondeductible contribution enters a Traditional IRA, it does not come out completely until all your Traditional IRA accounts are drained of all money. All your Traditional IRA money is considered by the IRS to be in a single pot, and you can't set up a Traditional IRA (possibly with a new custodian) via nondeductible contribution, convert just that Traditional IRA account into a Roth IRA account, and claim that the whole conversion amount is nontaxable because all the tax-deferred money is in the other IRAs that you haven't touched at all.

Last - you disclosed that you are depositing to a Roth 401(k) to the match. Which prompts me to ask if this is best. If your marginal rate is 25% or higher, you are missing the opportunity to save 'off the top', at that rate, and 'fill the lower brackets' at retirement, or, via conversion, any year before then when you are in a lower bracket for whatever reason. See my answer for Saving for retirement: How much is enough? which addresses this further.

From new comments -

Won't his Roth 401k contributions max out his overall Roth contributions?

No. They are separate numbers, each with own annual limits.

Wouldn't this prevent any back-door Roth conversions?

The 401(k) has no effect on back door Roth, except for the fact that the 401(k) and high income make the Roth IRA unavailable by normal deposit. Back door is the only door.

At the end are you encouraging him to look for a Traditional 401(k) at work to max out, then contributing to a Roth?

Yes! Read the linked SE article, and consider the annual withdrawal that would get you to 25%. As I wrote, it would take $2M+ to 'fill' the 15% bracket at retirement.

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    Depending on the value of the existing Traditional IRA and its pre-existing basis, if any, the backdoor Roth conversion might be almost completely taxable. Example: Traditional IRA worth $250K with zero basis. New nondeductible contribution increase value to $255.5K and basis $5.5K. Converting $5.5K into a Roth IRA leaves $250K in the Traditional IRA with basis $5381.60. That is, of that $5500 conversion, only $118.40 was nontaxable and so, not only is the original $5500 taxable income to the OP but he also owes taxes on $5381.60 of that $5.5K conversion. (Continued) – Dilip Sarwate Apr 20 '17 at 23:24
  • In short, discussions of backdoor Roth conversions as a great idea should always be tempered with an acknowledgement that it does not work very well if there is any other money in the Traditional IRA. Once that nondeductible contribution enters a Traditional IRA, it does not come out completely until it is drained of all money. All your Traditional IRA money is a single pot, and you can't set a Traditional IRA with a new custodian via nondeductible contribution, convert it to Roth IRA, and claim that the whole conversion amount is nontaxable; the tax-deferred money is in the other IRAs. – Dilip Sarwate Apr 20 '17 at 23:34
  • @DilipSarwate - exactly. Did I not hit that point hard enough? Agreed, it should be your whole paragraph. – JoeTaxpayer Apr 21 '17 at 0:04
  • @JoeTaxpayer Won't his Roth 401k contributions max out his overall Roth contributions? Wouldn't this prevent any back-door Roth conversions? At the end are you encouraging him to look for a Traditional 401(k) at work to max out, then contributing to a Roth? – Xalorous Apr 21 '17 at 18:21
  • @Xalorous - i edited in responses to these questions. – JoeTaxpayer Apr 21 '17 at 18:29
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Anybody can contribute to a traditional ira up to the maximum limit.

Does it make sense to contribute to a non-deductible IRA?

There are a couple of cases where it does:

If you're 59 1/2 or older, you're old enough to make IRA withdrawals without penalty. If you choose investments that maximize the value of tax deferral, you can use the nondeductible IRA to manage your tax burden.

If you're aware of an upcoming change in tax law that will benefit high earning individuals, it might be beneficial to use a nondeductible IRA. For example - you know that income limits for converting a traditional to a Roth are going to change in the coming year. You set up a nondeductible IRA with the intention of converting it the next year, so you can get around Roth contribution rules.

Beyond these cases, the main argument for contributing to a non-deductible IRA is -- compounded returns. If your IRA has a strong, steady growth rate, compounded returns can work wonders for your contributions. Let's take a hypothetical...

You are 35. You contribute the max amount of $5,500 every year until you retire at 70. With a modest growth rate of 9.5%, your total contribution of 193K would become 1.46M. The compounded returns are 7.6 times your contributions.

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    To clarify, if one contributes to a non deductible traditional IRA, does one still have to pay income taxes on withdrawals? – Vality Apr 20 '17 at 21:08
  • The IRS will tax the portion of IRA that comes from income/gains your nondeductible contribution generated between time of contribution to time of withdrawal. To figure out how much of the IRA the IRS will tax - you need to monitor how much of its balance comes from nondeductible contributions and how much comes from income, then take correct proportion from each. – Lochsmyth Apr 21 '17 at 15:53
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Yes, you may make non-deductible contributions to an IRA.

The main benefit of a non-deductible IRA is tax-deferred earnings. If the investment pays out dividends, they will be kept in the IRA (whether you take them in cash and put them in a Cash Management Account, or you automatically reinvest them).

You do not get taxed on these earnings until you withdraw from the IRA during retirement. If your income at that time is significantly lower than your income while you're working, you will be in a lower tax bracket (unless tax rates change drastically between now and then), so the taxes you pay on these earnings will be lower than if you'd invested outside the IRA and paid taxes along the way. You also get the benefit of compounding of the tax-deferred earnings.

There's one caveat -- when you withdraw from the IRA, all the growth is treated as ordinary income. Even if some of it is capital gains, it will be taxed at your ordinary income rate, not your capital gains rate. So this is most beneficial for investments that produce dividends.

If you have a mix of deductible and non-deductible contributions to your IRA, the tax on the principle portion of your withdrawals is pro-rated based on the ratio of deductible to total contributions. This ensures that you eventually get taxed for the deductible portion (it's not really tax-free, it's tax-deferred), but don't get taxed twice for the non-deductible portion.

Another option, if your 401(k) plan allows it, is to make after-tax contributions to the 401(k). At the end of the year, you can make an in-service distribution of these contributions and their earnings from the 401(k) to a Roth Conversion IRA. This allows you to contribute to a Roth IRA even if you're above the income limit for normal Roth IRA contributions. You can also do this even if you're also making non-deductible contributions to your regular IRA.

  • Yes, and +1. But, if OP has no other IRA money, why not convert to Roth immediately? Then, it's tax free for life, or at least until congress decides to confiscate it. – JoeTaxpayer Apr 20 '17 at 22:18
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    @JoeTaxpayer Good point. I'd forgotten that they got rid of the income limit on Roth conversions, thus enabling backdoor Roths. – Barmar Apr 20 '17 at 22:21
  • Right. It's currently a 'too good to be true' opportunity. For whatever reason, it's still permitted. And a big welcome to you here. I tip my hat to your 300K SO rep. – JoeTaxpayer Apr 20 '17 at 22:23

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