One benefit of making contributions to any retirement plan (other than the knowledge that you’ll have money after you retire) is the fact that those contributions can be deducted from your current income for tax purposes.
However, if either you or your spouse are covered by an employer-sponsored retirement plan, a contribution to a traditional IRA may not be tax-deductible.
While some IRA contributions might not be tax-deductible, there are other reasons to contribute to an IRA.
You can figure out if you do qualify for a deduction based on your income
If you’re not covered by an employer-sponsored retirement plan, you can make an IRA contribution of up to $5,500 per year ($6,500 if you’re 50 or older) that is fully deductible regardless of your income.
If you’re covered by an employer retirement plan, your IRA deductibility is determined by your income, and looks like this:
- Single—with a modified adjusted gross income (MAGI) of between $63,000 and $73,000, after which the contribution is completely non-deductible
- Married filing jointly—with a MAGI of between $101,000 and $121,000, after which the contribution is completely non-deductible
If you’re not covered by an employer plan yourself, but your spouse is, the income phase-out looks like this:
- Filing jointly—with a MAGI of between $189,000 and $199,000, after which the contribution is completely non-deductible
Even if the contribution isn’t deductible, the earnings are still tax-deferred
Despite the fact that the contribution to a traditional IRA isn’t tax-deductible, the plan still offers the opportunity for you to accumulate tax-deferred investment income. That’s no small advantage.
If you earn an average 10% return in an investment brokerage account, and you’re in the combined federal and state marginal income tax brackets of 30% , then the return on your investment will be just 7%. But if the same 10% return were being earned in a tax-deferred traditional IRA account, you would get the full benefit of the 10% return.
Let’s do a quick calculation:
- If you have $10,000 invested in a taxable brokerage account, invested over 30 years at an average annual after-tax return of 7%, the account will grow to a value of $76,125;
- If you have the same $10,000 invested in a traditional, tax-deferred IRA account, invested over 30 years at an annual return of 10%, the account will grow to a value of $174,491
The contributions to either plan aren’t tax-deductible. However, because the traditional IRA is tax-deferred, the account increases in value by nearly $100,000 more.
Non-deductible contributions create a retirement tax diversification plan
It is entirely possible that by the time you reach retirement your tax bracket may be as high or higher than it is right now. That’s what can happen from a combination of Social Security income, employer pensions, and distributions taken from well-funded retirement plans.
However, if you have faithfully funded a traditional IRA account with non-deductible contributions, that portion of your plan will not be taxable upon retirement. Since there was no tax deduction going in, there’s no tax liability going out.
That means that at least some of your income in retirement will be tax-free, and that represents a tax diversification plan. Your future self will thank you forever!
A non-deductible IRA makes a Roth conversion less taxing
Millions of investors are converting other retirement balances, including traditional IRAs, to Roth IRAs. This is because distributions taken from Roth IRAs are tax-free, as long as you are at least age 59 ½ at the time of withdrawal, and the Roth IRA has been in place for at least five years.
That’s an incredibly powerful deal. But it comes at a price—you have to pay ordinary income tax on the amount of retirement assets converted to a Roth IRA.
That can represent a big chunk of the converted balance. However, if you’re rolling over traditional IRA accounts that include non-tax-deductible contributions, that portion of the rollover will not be subject to ordinary income tax.
That will make the Roth IRA conversion less taxing, and even more attractive.
Contributing even if you can deduct means a faster buildup of retirement savings
Even if you’re covered by an employer retirement plan, making contributions to a traditional IRA increases your ability to build up a large retirement nest egg.
For example, let’s say that you are maxing out your 401(k) contribution at $18,500 per year. Making a non-deductible contribution to a traditional IRA of $5,500 will increase the total amount of your contributions by more than 30%.
An increase in retirement contributions at this level holds open two important possibilities:
- A much larger retirement nest egg, for an even more comfortable retirement, or
- It greatly increases the possibility of early retirement.
Either outcome will put you in a better position than you would be otherwise.
And, if you want to make sure those contributions are making you the most money, also consider opening an account with Blooom. They’re a 401k and IRA management tool that will do the hard work for you. They’ll take into consideration your goals for retirement and rebalance your portfolio accordingly, plus you can speak to a financial advisor if you have any questions or concerns about your IRA.
You should contribute simply because you can
That may seem obvious, but it’s a point that shouldn’t be underestimated. While tax deductibility is certainly desirable when it comes to retirement savings, it’s not necessarily a deal-breaker if it isn’t available.
The fact is, virtually any type of savings represent potential retirement savings, but the traditional IRA simply has the advantage of also being tax-deferred.
A tax deduction is always preferred, but a non-deductible retirement contribution still goes a long way in making your retirement more enjoyable. Plus, there are benefits to contributing to a traditional IRA—such as diversifying your retirement portfolio, tax deferability, and more.
So the next time that you’re thinking about not making a contribution to a traditional IRA account because it won’t be tax-deductible, rethink that decision.
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