Pretax IRA contributions and traditional IRA contributions are the same thing. It gives you the ability to deduct contributions from your federal income tax. The tax deduction makes it financially superior to a non-deductible contribution. However, a non-deductible contribution does have financial advantages in some circumstances.
One reason you would consider non-deductible contributions is that contribution limits. Non-deductible contributions are already taxed. Once you make the contribution, the earnings grow tax-free until distributions begin (hopefully in a lower tax bracket). Instead of paying annual taxes on the earnings, the amount that would be paid in taxes is instead invested to compound earnings going forward. Additionally, non-deductible IRA contributions can be a gateway to other tax-advantaged opportunities.
What is a Pretax IRA Contribution?
A deductible IRA contribution essentially gets you a refund on the taxes you paid earlier in the year. Although the Solo 401k is significantly superior, if you don’t meet the self-employment qualification for a Solo 401k, you may still meet the qualifications for a pretax IRA. The pretax IRA qualifications are based on your income, filing status, and can be limited by your access to an employee-sponsored retirement plan at work (including self-employed). Something that changed recently is that the SECURE Act of 2019 now allows all retirees to contribute to traditional IRAs if they earn income. The previous contribution cutoff age of 70½ no longer applies.
Contributions must come from earned income. Social Security payments, pension payouts dividends, investment income, and other types of income don’t count. The most you can contribute to an IRA for 2021 is $6,000 if you’re younger than age 50. Workers aged 50 and older can add a “catch-up” contribution of $1,000, bringing the maximum IRA contribution to $7,000.
Your modified adjusted gross income (MAGI) does affect how much you can contribute. You must have earnings from work to contribute to an IRA, and you can’t put more into the account than you earned. In 2021, the full tax deduction is available to singles with a modified adjusted gross income of $66,000 or less and joint filers with income of up to $105,000. Deductions thereafter decrease and phase out completely once income reaches $76,000 for singles and $125,000 for joint filers. These annual limits are per person, not per type of account. You can split the maximum contribution between a traditional IRA and a Roth IRA.
What is a Non-Deductible IRA Contribution?
If you can’t currently qualify for a Solo 401k, a traditional IRA, or a Roth IRA, you can still put away additional retirement dollars where they can grow tax-free. It’s probably intuitive that a non-deductible IRA contribution is made with after-tax dollars. Therefore, you cannot deduct those contributions on your tax return. Still, many people turn to non-deductible IRA contributions when their income exceeds the allowable IRS tax-deductible contributions for a regular IRA.
In fact, non-deductible IRA contributions can be the gateway to a Mega Backdoor Roth Solo 401k. The Roth Solo 401k does have huge tax advantages. The earnings grow tax-free! Most importantly, the earnings remain tax-free when distribution withdrawals begin. The bottom line is that non-deductible IRA contributions can lead to tremendous tax savings in the long run.
Non-deductible contributions to a traditional IRA are subject to the same contribution limits as tax-deductible contributions. Your non-deductible contribution can be up to $6,000 in 2021, or $7,000 if you’re age 50 or older. The difference is in the contribution tax treatment.
For the non-deductible contributions, high income earners want to pay attention to the phase-out tables. After you reach the maximum tax-deferred limit for an IRA, you can make further non-deductible contributions up to the $6,000 or $7,000 limit. The major difference between a non-deductible IRA and a traditional or Roth IRA is that you can contribute to a non-deductible IRA no matter how much you earn.
Taxes can be significant if you exceed the limits of a tax-deferred or non-deductible IRA. The IRS will levy a 6% excise tax on the excess amount each year until you remove those savings if you save more than your yearly limit. That is a reason that most people do not exceed the IRS limit with non-deductible contributions.
When to Use Deductible, Roth, or Non-Deductible Contributions
Generally, you don’t want to make a non-deductible IRA contribution if you can tax-defer the full IRA contribution limit (AGI, or Adjusted Gross Income, of $76,000 for singles and $125,000 for joint filers in 2021).
Because these are non-deductible contributions, a primary appeal is for people with an AGI too high to make Roth IRA contributions (AGI of $140,000 for singles and $208,000 for joint filers in 2021). The appeal is that anyone with earned income can make non-deductible contributions to a traditional IRA.
If your AGI is less than the max, you need to calculate the non-deductible portion based on the phase-out that begins at $125,000 if single and $198,000 for joint filers in 2021.
Non-deductible IRA contributions deadline is April 15th (tax filing day). Contributions must formally elected by Dec. 31 of the tax year in a 401k or other salary deferral plan. It’s very important to keep careful records of your IRA contributions, both deductible and non-deductible. For any year in which you do make non-deductible IRA contributions, you need to include IRS Form 8606 with your federal tax return. This form documents your after-tax contribution, which is important once you begin taking distributions.
Annual contributions to a non-deductible IRA might be limited, but over time they do add up to real money. For instance, if you contributed $6,500 a year for 10 years beginning at age 50 and retired at age 60, assuming a 6% rate of return, your contributions could grow to more than $150,000 by age 70.
The Mega Backdoor Roth Solo 401k can bring even more tax advantages. When you make contributions to a Roth, you do it with after-tax dollars. When you convert non-deductible IRA contributions to a Roth, you’re converting after-tax dollars, too. After the conversion is complete, any investment growth within the account can be pulled out as a qualified distribution tax-free.
Can I Contribute to a Solo 401k and an IRA?
The simple answer is “yes”, you can contribute to a Solo 401k and an IRA. However, there are some limitations when it comes to deducting your IRA contributions if you participate in both types of plans. You may not be able to deduct all your traditional IRA contributions. That is if you or your spouse participates in a Solo 401k or another retirement plan at work. Not being able to take full advantage of the IRA tax deductions could be the reason you decide to make non-deductible IRA contributions instead.
It’s advisable to consult with a financial advisor before making any decisions.