Daperis CPAFixing a Retirement Account Mistake Before It Compounded
The situation
A client had made a contribution to a traditional IRA on advice from someone other than us, without realizing he wasn't in a position to benefit from it. He made too much income for the contribution to be deductible, and he was also covered by a workplace 401(k) with a much higher contribution limit than what an IRA offers.
The problem
A nondeductible contribution to a traditional IRA is a trap that looks harmless and isn't. You get no upfront deduction, but the growth still comes out taxed as ordinary income when you eventually withdraw it. You've effectively converted what should have been an investment taxed at long term capital gain rates into an investment taxable at much higher ordinary income rates, with none of the upfront tax deduction that's supposed to make a traditional IRA worth the tradeoff.
The good news is that there's a fix for this situation and mechanically, it works similarly to a backdoor Roth strategy. The first step is to convert the nondeductible contribution to a Roth IRA. Any gains on the conversion will be a taxable event, but you unlock future tax-free growth going forward. In many cases, paying the tax on a small recognized amount is a much better decision than letting your gains compound over the years.
While it sounds simple, even these strategies can't be analyzed in a vacuum. There are multiple five-year rules to consider, a pro-rata rule on conversions and additional tax filings that need to be accounted for, like including Form 8606 with your tax return to report your basis and the conversion. Despite all of this, when done correctly, a conversion to a Roth can make a huge difference in your financial situation.
Separately, the client wanted to save more for retirement than a direct IRA contribution would ever allow, and he was earning enough that his income sat inside the range where direct Roth IRA contributions phase out entirely.
What we did
We confirmed he had no other traditional IRA balances, so the pro-rata rule wasn't in play, and converted his $3,000 nondeductible contribution to a Roth IRA. The tax cost was minimal: with roughly $100 of growth accrued between the contribution and the conversion, the tax owed today came to about $24.
To address the broader retirement planning issue, we increased his pre-tax 401(k) contributions. This action served two purposes: it reduced his Modified Adjusted Gross Income (MAGI) to restore eligibility for a direct Roth IRA contribution, and it leveraged the higher contribution limits of the 401(k). This approach highlights a valuable planning strategy: pre-tax 401(k) contributions can effectively restore Roth eligibility. Rather than prioritizing one account type over the other, we recommend maintaining a strategic balance between pre-tax (Traditional) and after-tax (Roth) assets to support a comprehensive long-term financial plan.
The result
Left alone, that $3,000 would have grown for decades inside an account that taxed every dollar of growth as ordinary income on the way out. Converted now, for a tax cost of about $24, the same growth comes out completely tax-free. Assuming a modest 7% average annual return, that $3,000 could grow to roughly $11,600 over 20 years. Left as a nondeductible traditional IRA, close to $2,000 of that growth would have been taxed as ordinary income at withdrawal. Converted to a Roth, none of it is. A small, one-time tax cost today in exchange for real tax savings later, plus a client who came away with more shelter for retirement overall than the mistake he started with.
Keep It Simple / Key Takeaway 🍕
A small mistake caught early is cheap to fix. The same mistake left alone for twenty years is not. If something about your retirement accounts feels off, the cost of checking is almost always smaller than the cost of waiting.
This is an illustrative long-term projection based on an assumed rate of return. Actual results depend on market performance and cannot be guaranteed.
Client details have been changed to protect confidentiality. Some of these case studies are composites drawn from more than one engagement. Every situation is different, and the results described here are not a guarantee of similar outcomes.