Using Nondeductible IRA Contributions to Get Money Into a Roth IRA

The best of both worlds: tax-free growth and distributions

Couple using a laptop to compare their non deductible IRA contributions to a Roth IRA option.

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Roth IRAs are popular retirement savings vehicles because you can make tax-free withdrawals from them in retirement. What's more, required minimum distributions aren't mandated during the account owner's lifetime.

High-income individuals are often denied the opportunity to contribute to these accounts because of Roth IRA income limits. But they can still divert money into a Roth IRA indirectly by making nondeductible IRA contributions, which are contributions that you make to a traditional IRA with after-tax dollars.

Learn how to use nondeductible IRA contributions to overcome Roth IRA income limits and reap the tax benefits of a Roth IRA.

Nondeductible IRA Contribution Basics

Nondeductible contributions to a traditional IRA are subject to the same contribution limits and other rules as a traditional IRA. In 2020 and 2021, you can contribute up to $6,000 ($7,000 if you're 50 or older) to a traditional IRA. But the difference is how the contribution is treated for tax purposes.

Contributions to traditional IRAs are made with before-tax dollars, so you pay taxes when you withdraw the funds. Conversely, Roth IRAs use after-tax dollars, and you may take qualified distributions from these accounts without paying further income taxes. Nondeductible IRA contributions, in effect, use after-tax dollars for funding as you do not deduct these contributions on your tax return. As such, nondeductible contributions aren't taxed when they're distributed to you.

With your tax return, you will need to file Form 8606 to report the amount of your IRA contribution that was nondeductible. This is called your basis.

You can make both deductible and nondeductible contributions to a traditional IRA, but only the basis is tax-free; the deductible portion of the distribution is still taxable. To ease tracking and reporting purposes, it is advisable to open a separate account for all nondeductible contributions.

Getting Around Roth IRA Income Limits

Nondeductible IRAs are particularly useful for high-income earners, whose adjusted gross income (AGI) is often too high to make a Roth IRA contribution. For example, your ability to contribute as a single in 2021 starts to phase out at an income level of $125,000, increased from $124,000 in 2020. And Roth contributions aren't permitted at all for singles with an AGI of $140,000 or more in 2021, up from $139,000 in 2020.

If you fall into this category of investors, you might consider still making a nondeductible contribution to your traditional IRA. You can then convert the contribution into Roth IRA assets. This is sometimes called a "backdoor Roth IRA" strategy.

Getting Nondeductible IRA Contributions Into a Roth IRA

Through the backdoor Roth IRA strategy, those who earn enough money that they're not eligible to make a Roth IRA contribution can make a nondeductible IRA contribution each year and then convert it to a Roth IRA.

When you convert a traditional IRA to a Roth IRA, you'll pay taxes on any converted amount that is above your basis. If you have other IRA accounts, your basis must be calculated using a pro-rata formula.

For example, suppose you have $12,000 in a traditional IRA, and you make a $6,000 nondeductible contribution to a separate IRA account. You now have a total of $18,000 in IRAs. One-third of that amount is nondeductible, and the other two-thirds of the holdings are deductible.

It would be nice if you could convert just the nondeductible IRA portion. However, the IRS looks at all your IRA accounts combined. So, if you convert just $6,000, one-third of the converted amount (about $2,000) will be considered the basis, and the other two-thirds (about $4,000) will be considered taxable income for the year of the conversion.

The tax cost of converting a Roth will be only a small price to pay if your investments do their job and grow tax-free for many years inside your Roth IRA.

How to Avoid the Pro-Rata Basis Rule

The pro-rata basis rule does not apply if you have all your other retirement money in a 401(k) plan. You could then, each year, make a nondeductible IRA contribution, and assuming you immediately convert it to a Roth, the full amount of the conversion will be considered the basis.

For example, if you have $300,000 in a 401(k) plan and nothing in an IRA, you can immediately fund the IRA as a nondeductible contribution and convert it to Roth. The converted amount is not a taxable income as it was all basis.

You can also roll traditional IRA balances back into an employer plan, such as into a 401(k) plan, leaving only your nondeductible IRA balances outside of the plan so that in the future you can use the backdoor Roth conversion strategy without worry about accounting for pro-rata basis.

Keep only nondeductible contributions in your traditional IRA to avoid paying taxes when you convert them to a Roth IRA.

Tax Reporting

On the tax forms required, the IRS asks for year-end account balances as of the year you are filing the tax return (and Form 8606), so you would need to roll traditional IRA contributions into a 401(k) plan before year-end to use the conversion strategy that year.

If by year's end, you have no funds remaining in traditional IRAs, SEPs, or SIMPLE IRAs (perhaps because they were rolled into a qualified plan), that would leave you free to convert only the remaining nondeductible IRA contributions to a Roth IRA through the backdoor Roth IRA strategy. Future changes in tax law may change this strategy.

Nondeductible IRA Mistakes

The most common mistake made with nondeductible IRAs is forgetting to complete Form 8606 with your tax return. If you have made nondeductible IRA contributions but did not report your basis, you can report it in arrears.

Another common mistake is thinking you can convert only your nondeductible IRA contributions to a Roth. As discussed above, you have to look at the total of all your IRA accounts when determining the amount of tax owed when you convert to a Roth.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.