What is a Non-Deductible IRA?
Simply put, a non-deductible IRA is a retirement plan you fund with after-tax dollars. Any contributions you make to a non-deductible IRA are not tax-deductible. So while they are still IRA funds, they are unlike a Traditional IRA or Pre-Tax Solo 401k.
Contributions made to your non-deductible IRA can usually be withdrawn (tax & penalty free) at any time. Any gains you withdraw from your non-deductible IRA contributions are taxable, if you leave them in the original "non-deductible" IRA status.
The non-deductible IRA is similar to the post-tax (after-tax) "bucket" in your Solo 401k plan:
Non-deductible/after-tax contributions are not tax deductible, but may be withdrawn at any time
You'll pay taxes (and applicable penalties) on gains earned on your non-deductible/after-tax contributions
Non-deductible IRA contributions are documented on IRS Form 8606 and are subject to the same annual contribution limits as a Traditional or Roth IRA.
When would I use a Non-Deductible IRA?
Avoid Capital Gains Taxes
Some investors choose to make non-deductible IRA contributions if they earn too high an income to qualify for deductible IRA contributions. While the contributions may not initially be tax-deductible, the gains can grow tax-deferred until withdrawal.
Think of this example:
John Alexander wants to buy some cryptocurrency. He makes a non-deductible IRA contribution of $6,000 and invests those funds in Bitcoin
Later, John decides to sell his BTC at a profit
If John would have made that purchase with "taxable" funds, he would be subject to (short-term or long-term) capital gains on the sale of his crypto
Alternatively, if John buys the BTC with his non-deductible IRA, as long as the proceeds go back into his IRA the profits on the sale are tax-deferred until IRA funds are withdrawn
Backdoor Roth IRA Conversion
Another reason an investor might choose to utilize a non-deductible IRA is to perform a backdoor Roth IRA conversion. If an investor earns too high an income to make Roth IRA contributions directly, the "backdoor Roth IRA" may be a way to get funds into the tax-free vehicle.
Investors can make non-deductible IRA contributions, and then convert those funds to Roth IRA funds. If the contributions are converted to Roth before any gains have been made on the contributions, then the conversion is tax-free. That's because the funds are simply going from after-tax to after-tax. In a way, this makes Roth a designation of after-tax funds.
However, if the non-deductible IRA contributions were invested and showed gains - those gains/profit will be taxable upon conversion to the Roth IRA.
Non-deductible IRA contributions that are promptly converted to Roth IRA can be a great way to grow your retirement nest egg and eventually be able to take qualified distributions that are tax-free.
Can I Rollover Non-Deductible IRA funds into a Solo 401k?
Though it may seem counterintuitive, after-tax (non-deductible) IRA funds cannot roll into the after-tax (non-deductible) or Roth portion of your Solo 401k plan.
The IRS is clear non-deductible IRA funds must remain in either a traditional or Roth IRA and may not roll into a Qualified Retirement Plan.
Plan Fix-It: How to Correct a Rollover of Non-Deductible IRA Funds into Your Solo 401k
The IRS understands mistakes happen, and provides a plan fix-it if you rolled in non-deductible IRA funds to your Solo 401k.
If you've accidentally rolled over non-deductible IRA funds to your Solo 401k it's important those funds are removed as soon as you discover your error. In fact, Department of Treasury regulations state that you should distribute "the amount of the invalid rollover contribution, plus any earnings attributable to the employee within a reasonable time after such determination."
Fortunately, removing the funds shouldn't cause any tax penalties as you can simply roll the funds out to a Traditional IRA. Here are some best practices on correcting an accidental rollover of non-deductible IRA funds into your Solo 401k:
Remove the funds as soon as possible by depositing them into an IRA
Have your CPA complete IRS form 1099-R to document the rollover distribution
Use Distribution code G on Box 7 of IRS form 1099-R: This tells the IRS the rollover is a direct rollover to another retirement plan and should not be taxable