Guide: Self-Directed IRAs & Non-Deductible IRAs
Cassandra Kirby was recently quoted in this U.S. News & World Report article called “A Guide to Self-Directed IRAs”, and wrote this blog post as a follow-up piece with her full thoughts:
Self-Directed IRAs
A self-directed IRA is an account that allows you to hold different types of investments, like real estate or other investments that are normally prohibited from your typical IRA. The account owner is the person who is managing the account, and therefore they must take on the responsibility of due diligence and ongoing management of the underlying assets. You should be a pretty knowledgeable investor to open and manage a self-directed IRA, and you should also be aware of the risks associated with the underlying investments.
With a traditional IRA, you typically would invest in stocks, bonds, mutual funds and exchange-traded funds. With the self-directed IRA, you can also invest in alternative investments like real estate, undeveloped/raw land, metals, commodities, limited partnerships, etc.
Not all custodians allow self-directed IRAS (SDIRAs), nor do they all allow the same types of investments. You will need to be sure that what you are hoping to invest in is available with the custodian you choose. The Better Business Bureau (BBB) is an invaluable tool when researching IRA custodians.
Self-directed IRA accounts, like regular IRAs, allow you to partake in the tax deductions or the other tax advantages of owning this type of account, for example, the ability to grow the asset tax-deferred or tax-free over time. Also, they give you the ability to invest in something you may feel passionate about, and lastly, they can be a good diversifier from your other portfolio holdings; however, you need to stay on top of due diligence and the risks associated with the underlying investments. You should also be mindful of fees and any associated penalties and be careful that you do not complete any transactions that could put you at risk for owing tax and penalty on the entire balance of the account, known as prohibited transactions.
Non-Deductible IRAs
A non-deductible IRA holds funds that were contributed on an after-tax basis and for which you did not receive a tax deduction at the time of contribution. When withdrawn later in life, the contributions themselves are considered a return of principal and only the earnings are taxable at your ordinary income tax rate. Non-deductible IRA contributions should be kept track of by your tax preparer on Form 8606.
There are income eligibility limits that may disqualify you from making a pre-tax or traditional IRA contribution and receiving a tax deduction. In addition, whether you have a retirement plan through your employer may disqualify you from making regular tax-deductible IRA contributions. This is one reason people utilize after-tax IRAs (non-deductible).
If your income is too high and/or your employer’s retirement plan participation disqualifies you from making a partial or full deductible contribution, you can make after-tax contributions and still receive the benefit of growth over time in a tax-qualified vehicle, meaning capital gains, dividends and interest are not taxed in the year in which they are earned, but rather at the time of distribution. Do remember that after-tax IRAs are still subject to the 10% early withdrawal penalty if withdrawn prior to obtaining age 59 ½ on the taxable portion.
After-tax IRAs are often used by individuals in the process of completing back-door Roth strategies. The concept behind the back-door Roth strategy is that if your income is too high to make regular Roth contributions, you can establish an after-tax IRA, deposit monies (up to annual limits) and then convert them to a Roth in a short period of time with little to no tax due. Then, these after-tax to Roth monies can enjoy all the benefits of regular Roth IRA contributions.
With the back-door Roth you need to be mindful of the pro-rata tax allocation – meaning that if you have any other traditional IRA accounts and you complete an after-tax contribution and subsequent Roth conversion, you will be taxed on the pro-rata portion converted. If you have no other pre-tax IRA accounts, or if you have rolled them into a 401(k), you should be able to complete the back-door Roth strategy tax-free. For example, if you have $20,000 of pre-tax IRA contributions and you do a $7,000 after-tax contribution and then convert it to a Roth, only 26% of your $7,000 will be tax-free ($7,000/$27,000). The remaining 74% will be included in your taxable income for the year.
If you are not using the after-tax IRA to Roth strategy, it is very important to keep track of your deductible versus non-deductible contributions so that you do not end up paying more tax than you should over your lifetime.
Deciding how to save for retirement and what vehicles make the most sense is based on a series of different factors which include, but are not limited to, your income, your tax bracket (both today and anticipated in retirement), your spouse’s income, and your lifestyle needs in retirement. Working with a qualified financial advisor and/or tax professional is a great way to gain the knowledge and confidence to save for your future in the most efficient way.
Check out the previous piece in our series on retirement accounts, “The Main Differences Between 401(k)s and IRAs”, and tune in next week for the final piece in the series called “Items to Consider Before Cashing Out or Rolling Over a 401(k)”.
~Cassandra Kirby, COO/CCO of Braun-Bostich & Associates
To discuss this content further or to ask any financial-life question you may have, we encourage you to reach out to us at 724.942.2639 or schedule a FREE/no-obligation time to chat with an advisor at your convenience.
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