Some tax filers are not able to directly fund a Roth individual retirement account because their income is too high. Individuals with too much income to directly fund a Roth IRA may contribute to a nondeductible traditional IRA and then roll those funds over to a Roth account.
Contributions to a traditional IRA are not always fully tax-deductible, so many accounts consist of both pre-tax and after-tax amounts. When a traditional IRA is initially opened, it is not designated as deductible or nondeductible. There are income ranges within which the deduction is reduced and eventually eliminated, even though the contribution is made.
Funding a nondeductible IRA
Even if you earn too much to deduct an IRA, you may still contribute to a nondeductible IRA. As with a deductible IRA, the interest earned on a nondeductible IRA is not taxed until eventually distributed. Because there is no up-front tax deferral, a nondeductible IRA has diminished value for most tax filers.
Converting to a Roth account
A nondeductible traditional IRA may be used as a conduit for higher-income earners to fund a Roth IRA. Under current tax regulations, you may convert the nondeductible traditional IRA to a Roth IRA. There is generally no income restriction on who is able to convert a traditional IRA to a Roth IRA.
A conversion from a nondeductible traditional IRA to a Roth IRA is a qualified rollover, so there is no early distribution penalty. If you own no other pre-tax IRA account balances, the rollover is tax-free since tax is already paid on the nondeductible contribution.
There has to be some method to keep track of nondeductible contributions each year, and that is accomplished by the use of IRS Form 8606. The form is filed with your tax return to report the conversion of a traditional IRA to a Roth account.
Possible 2016 changes
There are possible changes ahead limiting your ability to convert a nondeductible traditional IRA into a Roth account. A 2016 federal budget proposal contains language that would prevent the rollover of nondeductible IRA funds into a Roth account.
Even if the proposed change becomes effective, a nondeductible traditional IRA may still be useful for some individuals. Although you cannot deduct the contribution, interest earned on a nondeductible IRA provides tax-deferred earnings until withdrawn at a later date.
Funding a Roth account is the best option since accumulated earnings are not taxed when eventually withdrawn. Contact a financial advisor for more information on retirement account rollovers.