With the new year many investors vow maximize contributions to individual retirement accounts and 401(k)s.
To overcome their reservations, many focus on the tax deductions, which are allowed on most 401(k) contributions and for IRAs if one meets the criteria.
Put $10,000 into a 401(k) over the year and you might save $2,500 in federal income tax, assuming a 25 percent tax bracket. And the maximum contribution is pretty high — $18,000 a year, or $24,000 for investors 50 and older. Business owners and people who work for themselves can also add a share of their profits. The IRA limit is $5,500, and $6,500 if older than 50.
Some investors have a chance to make non-deductible contributions but shun this potentially profitable option.
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“Oftentimes people get hung up on the tax deduction and see non-deductible contributions as somehow inferior,” says planner Adam M. Grossman, founder of Mayport, a Massachusetts planning and investment firm, citing tax deferral on gains until money is taken out in retirement.
“Yes, all things being equal, especially if you’re in a high tax bracket, everyone likes a deduction. But, if an IRA contribution isn’t going to be deductible, that doesn’t mean that it’s not worth doing,” he says. “I see non-deductible contributions as wholly underrated savings strategies.”
Which investors face this dilemma?
Business owners and self-employed people can sometimes set aside more by making non-deductible contributions to retirement accounts on top of deductible ones.
Also, many investors who do not qualify for a tax deduction on a traditional IRA can make a non-deductible contribution instead. Federal rules, for example, say a married couple filing a joint return cannot deduct contributions if income exceeds $121,000 in 2018 and the contributor is covered by a retirement plan at work. If the contributor is not covered by a workplace plan but the other spouse is, there’s no deduction if income exceeds $199,000.
But the couple could make non-deductible contributions to get the benefit of tax deferral on investment gains until withdrawals are made.
A number of factors should be considered first.
Figure your situation. Obviously, if you can deduct a retirement-plan contribution, it would be a better option than a non-deductible contribution. Most plan participants can get tax deductions on 401(k) contributions, but not everyone can do so with a traditional IRA. (Check the IRS website for details.)
[See: 11 Steps to Make a Million With Your 401(k).]
“The tax rates an investor is subject to today versus what rates he or she expected at retirement is probably the biggest consideration or opportunity for making non-deductible contributions,” says attorney Tom Foster, a retirement-plan expert at MassMutual, the life insurance and financial services firm. He adds that individuals with big incomes are prime candidates.
The Roth option. Experts say a better alternative by a long shot is the Roth-type IRA or 401(k), if available.
“There is no need to make a non-deductible contribution to a traditional IRA if the investor is able to contribute directly to a Roth IRA,” says Thomas Walsh, a planner and portfolio manager with Palisades Hudson Financial Group in Atlanta.
Unlike traditional accounts, Roths do not provide tax deductions on contributions, but they do allow contributions and investment gains to avoid any annual taxes that would apply to a taxable account, and to be withdrawn tax free after the investors turns 59.5. So if you’re going to miss out on a deduction on contributions anyway, why use a traditional account that would incur taxes the Roth would not?
Unfortunately, not everyone can open a Roth IRA. To contribute, a spouse in a married couple filing jointly must have an income below $199,000 this year, for example. So some couples do not qualify for either a Roth or a deduction on a traditional IRA, but could still put money into a non-deductible traditional IRA, and get tax deferral until money is withdrawn.
Walsh says that investors who cannot open Roth IRAs can contribute to a traditional IRA and then convert it into a Roth, a maneuver known as a back-door Roth.
Capital gains tax. As mentioned, an investor who makes non-deductible contributions to a traditional IRA will still get tax deferral on gains. But there’s a catch: withdrawals of gains will be taxed as income (the original after-tax contributions will not be taxed again). An alternative would be to invest in an ordinary taxable account, choosing holdings that provide returns through price increases subject to long-term capital gains. The long-term capital gains rate is 15 percent for most investors, usually lower than the investor’s income tax rate, and capital gains are not taxed until the asset is sold, giving the buy-and-hold investor a tax deferral similar to that in a traditional IRA.
Consider tax rates. The benefits of a Roth versus a traditional account largely depend on the investor’s tax brackets at the time investments are made versus when withdrawals are made after turning 59.5, when early withdrawal penalties no longer apply. Generally, it’s best to pay tax in the present if it will allow you to avoid a higher tax rate later.
That’s why many experts urge young investors with low pay at the start of their working lives to use Roth accounts — they won’t pay much tax in the present and with a Roth they will avoid tax when their rate is higher decades later. For someone in a low income-tax bracket, the upfront tax saving of a traditional account may not be as valuable as the tax exemption on a Roth later.
[See: What Everyone Should Know About IRAs.]
“Investors who anticipate that they would have a lower tax rate when they retire than in the current tax year would benefit the most from non-deductible contributions,” says Mario Costanz, CEO at Happy Tax, a tax preparation chain based in Miami Beach, Florida.
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How Non-Deductible Savings Pay Off originally appeared on usnews.com
