Strategies When Your IRA Contribution Cannot Be Deducted
By Sarah Brenner, JD
Director of Retirement Education
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The other day an advisor called us with an issue that comes up frequently, especially in these tumultuous times. His client had made an IRA contribution for 2021 and was planning on deducting that contribution. However, his job situation changed, and he became an active participant in a retirement plan at a new job. While the new job and access to a retirement plan were good things, there was an unfortunate consequence. His IRA contribution could no longer be deducted for 2021. Why? He became an active participant in a plan and his income was too high for a deductible IRA. Here are some strategies to consider if you find yourself in this situation.
1. Withdraw the contribution. If the contribution is not deductible, you may decide that you do not want to make an IRA contribution at all. That is your choice and there is nothing wrong with that. You will need to remove the contribution and the net income attributable to it by October 15, 2022. There will be no excess contribution penalty and the contribution will not be taxable. Only the net income attributable will be taxable and potentially subject to the 10% early distribution penalty.
2. Recharacterize the contribution. If you are eligible, you may want to consider recharacterizing your nondeductible IRA contribution as a Roth IRA. There are income limits for making Roth IRA contributions, so this option will not be available to everyone. However, If eligible this can be a good strategy. Recharacterization is not a taxable transaction. The funds will be directly transferred to your Roth IRA. The deadline for making this choice is October 15, 2022.
3. Keep the nondeductible contribution. Maybe you want to keep the funds in the IRA, even if you cannot deduct the contribution. This can be done. You will need to file Form 8606 with your 2021 federal income tax return to claim this nondeductible contribution. In the future when you take distributions from your traditional IRA, these funds will be returned to you tax free.
4. Do a back-door Roth conversion. Here is a creative solution that may work for you if you are interested in a Roth IRA, but your income is too high to take advantage of recharacterization. You can make a nondeductible traditional IRA contribution and then convert it to a Roth IRA. This is called a back door Roth conversion. Unlike tax year Roth contributions, there are no income limits on conversions.
What strategy is best? It really depends on you and your retirements savings goals. You may want to discuss you situation with a knowledgeable financial advisor to be sure that you make the move that is right for you.
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