Nondeductible Traditional IRA
Many investors contribute to either a traditional IRA or Roth IRA. The latter offers its major tax benefit when you start withdrawing funds, while the former provides its primary tax advantage on contributions. While a nondeductible traditional IRA does not offer the same tax benefits of a Roth or deductible traditional IRA, you still benefit from the power of tax-deferred growth.
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Traditional v. Roth IRA
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To understand the way a nondeductible traditional IRA works, you must first know the ins and outs of Roth and deductible traditional IRAs. You contribute after-tax income to a Roth IRA, whereas contributions to a deductible traditional IRA--up to a pre-set yearly limit--are tax-deductible. When you turn 59 1/2, you are eligible to take penalty-free withdrawals, or distributions, from both types of IRAs. With a Roth, your money, even earnings, comes out tax-free. The Internal Revenue Service treats traditional IRA distributions as regular, taxable income.
How a Nondeductible IRA Works
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A nondeductible traditional IRA does not provide all the perks of Roth or deductible traditional IRAs. According to Dr. Don Taylor of Bankrate.com, a nondeductible traditional IRA still offers a significant tax benefit--the beauty of tax-deferred growth. Your money grows tax-free as long as you keep it tucked away in your account. Taylor points out that even though your investments are not deductible, you are still bound by the yearly contribution limits of your account. Consult your tax adviser as these limits change periodically, based on legislative tweaks, your income and age.
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Benefits
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The Motley Fool's Dan Caplinger compares a $10,000, 30-year bond investment in a taxable account that pays 5 percent interest annually to placing the same amount in a nondeductible IRA with the same rate of return. The IRA money earns an additional $5,000 over 30 years, due to its tax-deferred status. With the taxable account, the IRS requires you to pay taxes on your gains every year.
Purpose
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Some individuals cannot contribute to Roth or deductible traditional IRAs. As Caplinger notes, the most common reason is that they earn too much money and contribute to an employer's retirement plan. In this case, it makes sense to take advantage of the nondeductible version of a traditional IRA to reap the rewards of tax-deferral.
Considerations
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When you withdraw money from a nondeductible traditional IRA, the IRS does not tax your original contributions (that would be "double-dipping" on the government's part), but you must pay income tax on the earnings you accumulate. As IRS Publication 590 details, another drawback--as with other types of IRAs--is that if you take your money out prior to turning age 59 1/2, the IRS slaps you with an additional 10-percent tax penalty. Taylor reminds investors that you must report non-deductible IRA contributions to the IRS, using Form 8086.
Expert Insight
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Caplinger advises that if you intend to invest in stocks, a nondeductible traditional IRA can be a bad deal. The main reason is that capital gains on stocks in a taxable account are taxed at a lower rate by the IRS than IRA proceeds, which are taxed at your regular rate. As an example, he notes that a $10,000 investment in Apple stock in 1999 would have yielded $12,554 after 10 years in a nondeductible IRA account. The same investment in a taxable account turned into $15,802 after 10 years. Those figures are based on a 15-percent capital gains tax rate and the 35-percent tax bracket.
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