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I get a 401k from my employer, and contribute the maximum amount ($18,500 annually) but I still have some money left over that I'd like to put to use. However, from what I understand, because I am single and my annual income is over $72,000, I do not get any tax deductions from depositing, even though I can deposit up to $5500.

It is also my understanding that I can roll traditional IRA money into a Roth IRA even though my income is also greater than the maximum typically allowed for a Roth IRA. I would prefer to do this since I can then pay less tax later in life, but I am not really sure how the benefits stack up when my income is higher than the deduction limit.

  • The single taxpayer income limit for a Roth IRA contribution is $133K, so you can contribute directly to a Roth without the back-door option in that case. – D Stanley Mar 27 '18 at 21:32
  • @DStanley Is that pre- or post-tax income limit? If pre-tax, that is a no-go. – SPavel Mar 27 '18 at 22:07
  • Roth IRA is always post-tax (the gains are tax-free but not the contribution) – D Stanley Mar 27 '18 at 22:09
  • I might have misunderstood your question - the limit refers to MAGI, which is AGI (after 401(k) and other pre-tax deductions) with some specific deductions added back. – D Stanley Mar 27 '18 at 22:15
  • Correct - it sounds like a back-door Roth is your best bet. – D Stanley Mar 27 '18 at 22:35
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There is a benefit of a non-deductible traditional IRA: tax-free growth. But it's inferior to both a deductible traditional IRA and a Roth IRA. However, it could end up being a worse deal than a taxable account, due to the fact that withdrawals from a non-deductible traditional IRA are not eligible for potentially lower capital gains tax rates. These accounts are best suited for tax-inefficient investments like bonds.

As mentioned, the most useful thing about a non-deductible traditional IRA is it can, in most cases, be converted to a Roth IRA with minimal or no tax. This is called a backdoor Roth IRA and can be used to avoid the income limits on direct Roth IRA contributions. It has even been blessed by Congress. However, one thing to watch out for is that you don't have a pre-tax IRA balance (e.g. a rollover IRA from a past 401(k)) on December 31 of the year in which you do a conversion. Even if it's a different account, or a different brokerage, that will cause your conversion to be partially taxable.

  • So what you are saying is that if I create a traditional IRA right now, I would have to convert it before December 31st, 2018? Can I just create a new IRA every January and ninja-flip it into a Roth IRA after 11 months? – SPavel Mar 28 '18 at 1:31
  • @SPavel No, I'm saying your IRA balance on December 31, 2018 will determine the taxes on a conversion done in 2018. Ideally this balance will be $0 and so you will only be taxed on earnings between the contribution and conversion. – Craig W Mar 28 '18 at 1:35
  • @SPavel: No, the nondeductible contribution and conversion don't have to be in the same year. What he is saying is that you shouldn't have any pre-tax amounts in your Traditional IRA on December 31 of the year you convert. For example, if you have pre-tax amounts in your Traditional IRA from before, you can rollover the pre-tax amounts to a 401k before you do the backdoor to solve this problem. But even after you do the backdoor (nondeductible contribution + conversion to Roth IRA), you must make sure not to do another pre-tax contribution that same year. – user102008 Mar 28 '18 at 5:19
  • @user102008 but how can I have pre-tax amounts if I don't get a deduction? – SPavel Mar 28 '18 at 11:04
  • @SPavel Your situation may have been different in the past such that you qualified for a deduction. Or you could decide to rollover your 401(k) into a traditional IRA. Both of these would be pre-tax IRA money that would impact taxes on your conversion. – Craig W Mar 28 '18 at 11:08
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If you take a non-deductible contribution to a traditional IRA and roll it over to a Roth IRA, you get the normal benefits of a Roth IRA. This is often called a Backdoor Roth IRA.

It may help you to know that if your tax rate is the same at both contribution and withdrawal, traditional and Roth IRAs have the same benefit. Take $1000. Pay any tax (say 25%) for the Roth. Invest in something that quadruples. Withdraw the whole amount after retirement. Pay tax (still 25% or whatever) on the traditional. You end up with the same amount.

The Roth starts with $1000 less $250 taxes = $750. Amount quadruples to $3000, and is tax-free upon withdrawal.

The traditional starts with $1000. Amount quadruples to $4000. Withdraw it all and pay $1000 (25%) in taxes. $3000 left.

The Roth gives less benefits if the tax rate you pay in retirement is lower than the tax rate you pay now. It could conceivably give more benefits if your tax rate after retirement would be higher, but most people won't make more money in retirement than they do now. Perhaps taxes will increase, as revenue is currently lower than spending.

You can actually contribute more with the Roth IRA. This is be cause if you start with (e.g.) $6400, pay $1600 in taxes, and then contribute $4800 to the Roth IRA, that is the equivalent of a $6400 contribution to a traditional. But you can't make a $6400 contribution to a traditional; you are limited to $5500. So a Roth IRA's $5500 limit is the equivalent of a $6875 limit for a traditional.

Non-deductible contributions to a traditional IRA still get tax deferral on earnings. So you don't have to pay tax on capital gains and dividends until you withdraw.

Even if you get no special tax treatment, traditional IRAs receive protection in bankruptcy.

If you retire early, you can convert traditional IRA funds to Roth IRA funds and take the income before you get Social Security. So you might find your rate lower. This also may help you bridge the years between 62 (when you can first take Social Security) and full retirement age (when you get the maximum benefit from Social Security).

  • +1 I added a few words to the 3rd and 4th paragraphs to clarify your example. Please roll back if you don't like the edits. – Dilip Sarwate Mar 28 '18 at 3:03

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