Nondeductible IRA: Understanding Tax Benefits & Retirement Savings

A nondeductible IRA account is a good tool to use to save for retirement and receive tax benefits. A traditional IRA, rather than a nondeductible IRA, offers a tax deduction in the current year. The money you save is deducted from your income each year before you file your taxes. You can deposit money only up to an annual limit. With a nondeductible IRA option, you do not receive a tax deduction when you put the money into the account. This option was created so people could deposit funds in excess of the annual deductible maximum. However, the nondeductible option has become much less appealing with the introduction of the Roth IRA.

Roth IRA Legislation

The Roth IRA provides the benefits of a nondeductible IRA and then some. With the Roth model, an individual can place post-tax dollars into the qualified account with no deduction in the current year. Just as with the nondeductible option, the money grows tax free while in the account. The unique benefit with a Roth IRA is the fact that you do not have to pay taxes in the future. This is particularly advantageous if you have low income currently. A tax deduction this year would not help you much, but a tax deduction in the future could be of great advantage.

Problems with the Roth Option

The biggest drawback of the Roth option is its low limits. In 2010, you can contribute up to $16,500 to a qualified retirement plan, dependent on your income. However, only $5,000 of this may be contributed to a Roth IRA or Roth 401k. The model is designed to benefit low-income individuals who contribute relatively low levels of income each year. It is not designed to meet the needs of an individual depositing a large sum into retirement funds annually.

Blending the Roth with a Second Account

One choice many individuals make is to have both a Roth account and another IRA account. They use the Roth account for the first $5,000 of savings, or whatever the annual maximum is in the current year. The second account catches the overflow up to the total annual maximum. If you choose to have two accounts, the next decision is whether to use a nondeductible IRA for the second account or a traditional IRA. In many cases, the nondeductible IRA will not present any advantages.

Nondeductible vs. Traditional

With both a nondeductible and traditional IRA deposit, the investments in a retirement account grow tax free. You owe taxes only upon withdrawal of the funds. The question is whether you can take a deduction on the deposit you made this year. With both a deductible and nondeductible deposit, you are placing funds into a qualified retirement account. Since there is no real difference in the account structure, and since both options present you with benefits in the future, it is best also to get benefits today. The best solution is usually to set up a traditional, deductible IRA in addition to your nondeductible Roth IRA. The money you place in the Roth is nondeductible but has large advantages in the future. The traditional IRA account is deductible, and it catches any overflow contributions from your Roth account.