What Is the Difference Between a Roth IRA and a Nondeductible IRA?
Two common types of individual retirement accounts (IRAs) are traditional IRAs and Roth IRAs. Typically, traditional IRA contributions are tax-deductible, while Roth IRAs allow tax-free withdrawals at retirement. However, in some cases the contributions to traditional IRA accounts cannot be deducted, so the contributions are referred to as nondeductible contributions.
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Eligibility
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To contribute to a Roth IRA, you must have an adjusted gross income below the annual limits. These limits adjust each year and are different for different filing statuses. For 2010, you can make a contribution to your Roth IRA if your adjusted gross income is below $120,000 if you are single, $177,000 if you are married filing jointly or below $10,000 if you are married filing separately. You can make nondeductible contributions to a traditional IRA if you (or your spouse) are covered by a retirement plan through your employer and your adjusted gross income exceeds the annual income limits. For 2010, the annual limits are $66,000 for singles, $109,000 if you are married and you are covered, $177,000 if you are married and only your spouse is covered, and $10,000 if you are married and you file a separate return.
Tax Treatment for Early Withdrawals
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Since contributions made to both Roth IRAs and nondeductible IRAs are made with after-tax dollars, contributions can be withdrawn tax-free and penalty-free. When you make an early withdrawal from a Roth IRA, the contributions come out first. Only after you have withdrawn all of the contributions from your Roth IRA does your withdrawal take out the earnings. For nondeductible IRAs, however, the withdrawal comes out proportionally out of nondeductible contributions, which are tax-free and penalty-free, and other monies, which are subject to early withdrawal penalties. For example, if you had $20,000 in your traditional IRA, including $5,000 from nondeductible contributions, you would have 25 percent of your withdrawal come from nondeductible contributions.
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Tax Treatment at Retirement
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When you reach retirement age, which is 59 1/2 for IRAs, you can start taking qualified withdrawals from your IRA accounts. All Roth IRA withdrawals at retirement are tax-free, including earnings on the contributions. Distributions at retirement from traditional IRAs that include nondeductible contributions are split proportionally between withdrawals of nondeductible contributions, which are tax-free, and other funds in the account, which are taxable.
Benefits
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The tax benefits of a Roth IRA are significantly greater than the benefits of making nondeductible contributions to a traditional IRAs because the entire amount of the distribution is tax-free at retirement. However, if you are ineligible to contribute to a Roth IRA, you can still take advantage of the tax-sheltered growth that a traditional IRA offers, even if you cannot deduct the contributions.
Considerations
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Starting with nondeductible contributions made in 2006, the IRS allows people to convert nondeductible contributions in a traditional IRAs to a Roth IRA. When you roll over money from a traditional IRA, you typically have to pay taxes on the amount of the conversion. However, when nondeductible contributions are included in the rollover, you do not have to include the nondeductible contributions as taxable income. For example, if you have a traditional IRA worth $25,000 with $9,000 in nondeductible contributions, you would only have to pay income taxes on $14,000 if you rolled the entire amount into a Roth IRA. Beginning in 2010, the IRS removed all income restrictions on who could convert money from a traditional IRA to a Roth IRA so you can simply make a nondeductible contribution to a traditional IRA and roll it into a Roth IRA.
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References
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