A non-deductible IRA is a financial planning tool that has been around for a long while. The tax code allows taxpayers with earned income from wages and/or self employment income to contribute to an IRA, regardless of their income level. Therefore, a contribution would be made with after tax dollars into the IRA but the earnings would be tax deferred until withdrawn. The non-deductible IRA has not been popular in the recent past, due to the recent low tax rates on qualified dividends and capital gains.
A Roth IRA is one where contributions are made with after tax dollars but all of the withdrawals are tax free when withdrawn. There are income limitations for contributions made to a Roth IRA. One way around these income limitations is to make a contribution into a non-deductible IRA and then convert it into a Roth IRA, also known as a “backdoor IRA”. Currently, there is no income cap to make this conversion. The taxpayer would owe the tax on the difference between the converted value and the amount contributed. So if you make a contribution to a non-deductible IRA and then convert it to a Roth IRA, as soon as the contributions post, the tax impact should be negligible. However, if you convert a traditional IRA to a Roth IRA the taxpayer would have to add the amount converted to his or her income.
President Obama’s Patient Protection and Affordable Care Act included a 3.8% Medicare tax on investment income from dividends, interest, passive income, and capital gains. This tax is applicable to high-income earners, who are those with more than $200,000 of adjusted gross income as a single taxpayer and $250,000 for taxpayers filing married filing jointly. This new tax has reignited interest in the backdoor IRA. Since earnings from a Roth IRA are exempt from tax upon withdrawal, they escape this new 3.8% Medicare tax.
There are limitations. The maximum contribution to a non-deductible IRA for 2012 is $5,000 ($6,000 if over 50) and $5,500 ($6,500 if over 50) for 2013. Although this is a small savings in any particular year, it can yield significant savings if this approach is continuously used year after year.
As always, you should consult with your tax adviser before making and contributions to determine if this investment approach is right for you.