A nondeductible contribution in the context of the Individual Retirement Account (IRA) industry refers to money that you put into an IRA for which you cannot take a tax deduction. Different types of IRAs have different rules concerning the deductibility of contributions. With a traditional IRA, whether your contributions are deductible depends on your income, filing status, and whether you or your spouse are covered by a retirement plan at work.
Here’s a brief overview of how nondeductible contributions work:
- Traditional IRA with Nondeductible Contributions:
- If your income exceeds certain limits and you or your spouse have a retirement plan at work, you may not be able to deduct your contributions to a traditional IRA.
- The money you contribute can still grow tax-deferred, but you won’t get the upfront tax benefit that comes with deductible contributions.
- When you start withdrawing funds, the nondeductible contributions are not taxed again, but the earnings on those contributions will be taxed as regular income.
- Roth IRA:
- Contributions to a Roth IRA are always non-deductible regardless of your income level because the account offers tax-free growth and tax-free withdrawals in retirement (as long as certain conditions are met).
- Unlike a traditional IRA, there are income limits that can restrict the ability to contribute to a Roth IRA at all.
- Reporting Nondeductible Contributions:
- You must file IRS Form 8606 with your tax return if you make nondeductible contributions to a traditional IRA. This form keeps track of the total basis in your IRAs, so you don’t pay tax on the money when it’s withdrawn.
- Conversion to Roth IRA:
- Taxpayers sometimes make nondeductible contributions to a traditional IRA with the intention of converting to a Roth IRA later, a process known as a “backdoor” Roth IRA. This allows funds to potentially grow tax-free and be withdrawn tax-free in retirement.
It’s important to keep track of nondeductible contributions to avoid double taxation when the money is withdrawn. IRS Form 8606 is used to keep a record of this. It’s important to consult with a financial advisor or tax professional to understand the implications of nondeductible contributions based on your specific financial situation, as the rules can be complex and the tax benefits may vary.