You can defer taxes on the earnings and growth of your savings, just as you can with the rest of the money you’ve saved there. But your nondeductible contributions won’t reduce your taxable income in the year you make them.
IRA Savings Build for the Future
The growth on your savings can be very good, even if you don’t receive a tax break right away. That can make the contribution worthwhile in the long run if you expect to have a lower tax rate after you retire than you do now. You may want to pay taxes on earnings as you go, rather than defer taxation to a later time, if you expect your income and your tax rate to increase. You’ll pay taxes on the growth when you take your standard IRA distributions during retirement, but any savings that you didn’t deduct are treated as your basis in the asset. You paid tax on that money at the time you saved it, so you won’t have to pay tax on it again later. Suppose you made a $2,000 contribution one year ago that you didn’t or couldn’t deduct. Your account balance increases to $20,000 by the time you make a withdrawal, thanks to deductible contributions you made and investment growth. Only $900 of that money would be taxable income to you in this case if you were to make a $1,000 withdrawal during retirement, because 10% ($2,000 divided by $20,000) was your basis. This is a return of the portion of your savings that you didn’t deduct.
Contribution Limits for IRAs
Rules for IRA savings can be complex, and they adjust for inflation. It pays to review them each year. You can put a combined total of $7,000 into traditional and Roth IRAs in 2021 or 2022 if you’re age 50 or older. You can put a combined total of $6,000 into your traditional and Roth IRAs in 2021 or 2022 if you’re age 49 or younger. These limits don’t apply when you roll over funds from one account to another, or to qualified reservist repayments.
Income Restrictions for IRAs
You may not be able to deduct all that you save to a standard IRA, because you face certain income limits if you’re employed by a company that offers a workplace retirement account, such as a 401(k) or 403(b). This is the case regardless of whether you choose to participate in the workplace plan. These adjusted gross income (AGI) limits increase a little each year to keep pace with inflation. You can claim the full deduction if you’re filing as single or head of household, and if your AGI is $66,000 or less as of 2021. That increases to $68,000 for tax year 2022. You can also claim the full deduction if you’re married filing jointly or a qualifying widower, and if your AGI is $105,000 or less in 2021, or $109,000 or less in 2022. You can take the full deduction if your AGI is $198,000 or less in 2021 if you’re married filing jointly, and if your spouse is covered by a plan through work, but you’re not. This threshold increases to $204,000 in 2022. Deductions are phased out from these thresholds as your income rises. You’re subject to more stringent income rules if you’re married and filing a separate return, although you’re treated as a single payer by the IRS for these limits if you’ve lived apart from your spouse for the whole tax year.
Roth IRA As an Alternative
You may still be able to save to a Roth IRA if you’re covered by an employer-sponsored 401(k) and have income exceeding the limits for a regular IRA deduction. Roth IRAs have much higher income limits. It often makes sense to make a Roth IRA contribution rather than a nondeductible IRA contribution in this case. You can’t deduct either of them, but tax on the savings is deferred with a standard IRA—you’ll pay taxes on that money later—while Roth IRA savings grow tax-free.
The Bottom Line
Choosing the best approach for your savings can be an ongoing process. It can depend on your age, your income, and your retirement goals. Consult a professional to help you decide the best way to achieve tax-advantaged savings.
