Back around 2002, I got laid off in early January and worked the rest of the year as a private contractor with no benefits. When I did my taxes I contributed the max ($3K I think back then) to an IRA. Then a few years later the IRS contacted me and said my deduction wasn't allowed because I was covered by my employers 401K for that first week of January the year I was laid off. Tax owed, penalty and interest 🙁
So first of all – I was upset to learn that having a 401k for two weeks meant I couldn't contribute at all to an IRA. And second – I was even more upset that they wouldn't allow to to simply pull out the $3K or apply it to the following year. They told me I had to leave it in the IRA until retirement and I had to keep track of it (8606) So it felt like a huge PITA every year when filing taxes.
Now that I'm taking IRA distributions, I'm finding that this dumb mistake seems to be paying off for me since it reduces how much of my distributions are taxable. So why wouldn't everyone make non-deductible contributions to their IRA?
Google search tells me it's a bad idea because of the complications and because you'll probably forget and end up paying taxes on it twice (which is what I thought all these years until I actually started taking retirement distributions). Google also tells me that although I had the advantage of not paying immediate capital gains when buying/selling in the IRA (which allowed me to do a lot of trading that grew the portfolio a lot) – instead of the lower capital gains taxes I'm now paying higher taxes as income. So maybe I'm actually not getting the benefit that I thought I was getting? The math is over my head to try and calculate whether it turned out to be a big plus or a negative. But on the surface it sure seems like a plus to me so far. I doubt I would have done anything useful with the 3K if I hadn't accidentally put it in the IRA and now I have a nice distribution every year with a portion that isn't taxable. 🙂
Thoughts?
Interesting (I thought) outcome from an accidental IRA contribution 20+ years ago
byu/WilmaFinggerdew intax
Posted by WilmaFinggerdew
7 Comments
Because people making nondeductible contributions immediately convert those to a Roth so they don’t pay taxes on the earnings either.
Just make a Roth contribution
Unless your income is too high, why not simply contribute to a Roth. IRA. And if your income IS too high, do a back door Roth.
As someone whose IRA contributions became nondeductible ten years into my career, a Roth IRA made more sense to me than messing around with a regular IRA. If I wasn’t going to get the tax deduction up front, I might as well make the return on the contribution tax-free as well.
People are often blinded by the ability to take an immedate tax deduction. There is a “tax bomb” awaiting retirees due to taxation of IRA/401(k) distributions as ordinary income and taxation of Social Security that can make them subject to the IRMAA (income-related monthly adjustment amount) increase on Medicare parts B and D. If you have more than $109K in adjusted gross income and you are single or married filing separately ($218K if married filing jointly), it’s a 40% increase in your Medicare premiums. It’s 100% at $137K/$274K.
IRMAA applies two tax years after you exceed one of the income imits. I exceeded the IRMAA limit in 2024, so I am paying a surcharge currently that should go away in 2027. I expect a letter confirming this from Social Security in November.
Thanks for all the quick replies. And – DOH! face palm – Of course a Roth (I did start a Roth as well) would make more sense. Feeling silly it didn’t occur to me when I was asking the question here.
Anyway .. the stupid mistake I made with that contribution turned out to be less of a pain than I thought it would be. 🙂
You only get to take out the original nondeductible $3K tax-free. All of the investment gain is taxed.
If you had contributed to a Roth IRA instead, then the gain would also not be taxed on withdrawal.
If you had deducted the original contribution, you would have paid less tax back in 2002, which means you would have had more money to invest all this time.
A non-deductible contribution to a traditional IRA is strictly worse than either of these options. (But still better than no IRA at all)
What am I totally missing with the deduction issue? If you have a 401k you can still contribute and ohhhhh you didn’t earn enough w-2 income?