Tax Savvy: Use a Non-Deductible IRA

A tax law passed in 2006 adds a lot of appeal to non-deductible IRA contributions-just don't wait too long to take advantage of it.

Great rivalries of the past 60 years include the Lakers versus the Celtics, the Yankees versus the Dodgers, and the U.S. taxpayer versus the IRS. If you're part of a high-income, taxpaying household, consider giving yourself a winning advantage by making non-deductible IRA contributions this year.

When it comes to retirement contributions, current tax law doesn't favor high-income individuals. Income thresholds can disallow Roth IRA contributions and even phase out the tax deductions associated with contributions made to traditional IRA accounts. Here's a quick snapshot of the rules, and a look at why non-deductible IRA contributions have suddenly become more popular.

Non-deductible IRA contributions defined

The maximum allowed IRA contribution for 2008 is $5,000; this applies to the total amount contributed to any IRA, whether it's traditional or Roth. Taxpayers who aren't covered by an employer-sponsored retirement program can get a tax deduction for depositing that $5,000 into a traditional IRA. If the taxpayer or taxpayer's spouse participates in an employer's retirement plan, the available deduction phases out at higher income levels. This doesn't disallow the $5,000 contribution; it just disqualifies the taxpayer from taking the associated tax deduction. Contributions that don't qualify for the deduction are aptly named non-deductible IRA contributions.

Limitations on Roth IRA

Roth IRA contributions are never deductible, but the earnings and distributions are tax free. This is an attractive option for retirement savers, except that it's not available to everyone. Maximum income thresholds prohibit single taxpayers with adjusted gross incomes (AGIs) in excess of $116,000 from contributing to a Roth IRA. For married taxpayers filing jointly, the maximum AGI is $169,000.

Converting to a Roth IRA

Up until recently, the non-deductible IRA contribution had only one benefit-the contributor would get to defer taxes on the earnings within the account. Distributions, however, are taxed at regular income rates-not at the lower, long-term capital gains rate.

Starting in 2010, however, high-income taxpayers will be allowed to convert traditional IRAs into Roth IRAs. Those who earn too much to qualify for Roth contributions now have a new reason to make a traditional IRA contribution, even when they don't get a tax deduction in the current year. This is because in a couple of years, that money can be converted into a Roth IRA, where it will form the basis for a future stream of tax-free retirement income.

There's one caveat to note, however: Anyone who converts a traditional IRA to a Roth has to pay taxes on the pre-conversion earnings generated in the account. This is likely to be a small price to pay for future tax-free income. After all, earning money tax-free is the ultimate victory over your tax-collecting rival.