IRA access and tax breaks may expire for top earners
IRAs have an annual contribution limit of $7,000 for 2024. Investors age 50 and older can save an additional $1,000 this year, or a total of $8,000.
Investors who save in an IRA before taxes can usually deduct their contributions from their taxes. However, they generally pay income tax on earnings and withdrawals later. Roth contributions don't get the same tax break up front: Investors fund Roth IRAs with taxed money, but generally don't pay income tax on earnings or withdrawals in retirement.
However, many high earners cannot make optimal use of these tax-advantaged accounts.
For example, married couples filing joint taxes cannot contribute to a Roth IRA in 2024 if their modified adjusted gross income is $240,000 or more. The income limit for single filers is $161,000. (Eligibility begins to phase out even before these dollar limits, reducing the amount of contributions investors can make.)
Likewise, there are income limits on the deductibility of tax-free (also called “traditional”) IRAs for those who also have access to a workplace retirement plan such as a 401(k).
For example, single individuals earning $87,000 or more in 2024 cannot deduct contributions to a traditional IRA if they are covered by a workplace retirement plan.
The same is true for married couples filing a joint tax return. For example, if your spouse participates in a 401(k) plan at work, you can't deduct your IRA contributions if your joint income is $240,000 or more. If you're the one participating in the 401(k) plan at work, the limit is $143,000. (Again, you may only get a partial deduction below these dollar thresholds due to income phaseouts.)
The “only reason” to save in a non-deductible IRA
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However, high earners can contribute to a so-called non-deductible IRA.
This is a traditional IRA, but investors do not receive a tax deduction for their contributions; they fund the accounts with taxed money. Investors must later pay income tax on the growth when they withdraw.
According to tax experts, a major advantage of these accounts is the ability to use the backdoor Roth IRA.
This only applies to investors who earn too much to contribute directly to a Roth IRA or make a tax-deductible contribution to a traditional IRA, Slott said.
The basic strategy is this: A high-income investor makes a nondeductible contribution to his traditional IRA and then quickly converts the funds to his Roth IRA.
“The only reason you would do that [a nondeductible IRA] if the intent was to conduct a backdoor Roth,” Slott said.
After making the nondeductible contribution, Slott recommends waiting about a month before converting the funds to a Roth IRA. This will ensure that your IRA statement reflects the nondeductible contribution should the IRS ever ask for proof, he said.
Some investors may also be able to benefit from a similar strategy in their 401(k) plan, called a mega backdoor Roth conversion, which involves rolling over post-tax 401(k) contributions into a Roth account. However, this strategy is not available to everyone.
“All high earners should consider both a backdoor Roth IRA and a mega backdoor Roth IRA if they can't set up a Roth IRA,” said Ted Jenkin, a certified financial planner and founder of Atlanta-based oXYGen Financial. He is also a member of the CNBC Financial Advisor Council.
When a non-deductible IRA doesn't make sense
According to financial advisors, a nondeductible IRA probably doesn't make sense for investors who don't intend to use the backdoor Roth strategy. In such cases, the investor would simply leave the contributions in the nondeductible IRA.
For one thing, non-deductible IRA contributions come with potentially burdensome administrative and accounting requirements, Slott said.
“This is a life sentence,” he said.
According to Arnold & Mote Wealth Management of Hiawatha, Iowa, taxpayers must send a Form 8606 to the IRS each year to document their post-tax contributions to a non-deductible IRA. Withdrawals would add “even more complexity” to the administrative burden, it added.
Why taxable brokerage accounts are “probably better”
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Without a backdoor Roth, most investors would be better off saving in a taxable brokerage account than a nondeductible IRA, advisers say. That's because investors who use the former are likely to pay less taxes on their gains over the long term.
Taxable brokerage accounts “are probably better in most respects,” Slott said.
Investors who hold assets such as stocks in a taxable brokerage account for more than a year generally pay a favorable tax rate on their gains compared to other income taxes.
These “long-term” capital gains tax rates — which apply only in the year investors sell their assets — are as high as 20% at the federal level. (High earners may also have to pay a 3.8% “Medicare surtax” on gains.)
By comparison, the highest marginal tax rate is 37%. Investors in nondeductible IRAs are subject to these generally higher tax rates on earnings when they withdraw.
While investors with taxable brokerage accounts pay taxes on their dividend income each year, those taxes generally aren't enough to offset the relative tax advantages of such accounts, advisers say.
“Tax deferral on non-deductible IRAs can be a benefit for some,” says Arnold & Mote Wealth Management. “However, we find that this is quite rare.”
Additionally, investors in taxable brokerage accounts can generally access their funds at any time without penalty, while IRAs generally incur tax penalties if earnings are withdrawn before age 59½. (There are some exceptions with IRAs, however.)
Unlike traditional and non-deductible IRAs, taxable accounts do not require minimum distributions during the account holder's lifetime.
“A taxable account offers the flexibility to deposit and withdraw money without restrictions, penalties or limitations,” Judith Ward, a certified financial planner at wealth manager T. Rowe Price, recently wrote.