The Traditional Non-Deductible IRA
A traditional IRA, or individual retirement account, provides tax advantages for retirement savings. Typically, contributions are deductible and the money grows tax-free until it is withdrawn at retirement, with the withdrawals being included as taxable income. However, in some cases the contributions to the account are not deductible. A traditional non-deductible IRA is not a separate type of IRA; it merely signifies that the particular traditional IRA account has non-deductible contributions in it.
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Contributions
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Contributions made to a traditional IRA are non-deductible if your or your spouse have access to an employer-sponsored retirement plan and your income is above the annual threshold. The threshold changes based on your filing status and whether you or your spouse is covered. The thresholds change each year based on inflation. You can find the current thresholds in the most recent version of IRS publication 590.
Significance
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When you make a non-deductible contribution to a traditional IRA, the account increases its tax basis. The tax basis is important when you take distributions or if you choose to convert the money into a Roth IRA at some point in the future. When you take distributions from your traditional IRA that contains non-deductible contributions, you do not pay income taxes on the portion of the withdrawal that comes from the non-deductible contributions.
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Function
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When you take a withdrawal, you must calculate the percentage of your account that is made up of non-deductible contributions and then use the percentage to determine how much of your withdrawal is tax-free. For example, if your traditional IRA is valued at $40,000 and $10,000 is from nondeductible contributions, you would divide $10,000 by $40,000 to find that 25 percent of the traditional IRA is from non-deductible contributions. If you took a $5,000 distribution, you would multiply $5,000 by 0.25 to find that $1,250 of your distribution is tax-free. Then you would decrease the amount of non-deductible contributions left in your traditional IRA by $1,250.
Benefits
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Beginning with non-deductible traditional IRA contributions made in 2006, you are allowed to roll those contributions into a Roth IRA, which will allow you to take out all the money in the account, including earnings, tax-free, at retirement. When you perform the rollover, you do not have to pay income taxes on the non-deductible contributions, only the earnings in the traditional IRA.
Alternatives
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If you qualify to contribute to a Roth IRA, you are generally better off making the contribution directly to a Roth IRA. Eligibility to contribute to a Roth IRA is not affected by being covered by an employer retirement plan and the income limits for being eligible are much higher. The Roth IRA offers the same tax-sheltered growth as non-deductible contributions made to a traditional IRA but allows both contributions and earnings to be withdrawn tax-free at retirement.
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References
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