Taxation of Nondeductible IRA Contributions
Nondeductible traditional individual retirement accounts (IRAs) provide a limited tax benefit if you make too much to deduct your traditional IRA contributions or contribute to a Roth IRA. As its name would indicate, you can't write off your contribution; nor do you benefit from tax-free withdrawals, as you would if you contributed money to a Roth IRA. However, Internal Revenue Service rules that took effect in 2010 make nondeductible IRA contributions more attractive than before.
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Function
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As of 2010, the maximum amount you can contribute to your traditional and Roth IRAs is $5,000 if you are not yet 50 and $6,000 if you are 50 or older. Traditional IRA rules allow you to deduct your contributions from your income, provided you do not earn too much. Each year, the IRS publishes income limits that phase out high earners from taking a deduction. Separate limits apply to filers who are married, filing jointly; married, filing separately; and single or head of house. Income limits for taking a traditional IRA deduction apply only if you participate in an employer-sponsored retirement plan at work.
Phase-Out Limits
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Even if income limits phase you out of deducting your traditional IRA contribution, you can still contribute the maximum amount to a traditional IRA each year. In some cases, you may be able to deduct a portion of your contribution. For instance, in 2010 you can deduct the maximum traditional IRA contribution from your income if you are married, filing jointly and make up to $89,000. If you and your spouse make between $89,001 and $109,000, you can deduct a portion of the maximum. If your joint income exceeds $109,000, you cannot deduct your contribution.
To illustrate, imagine you are 45, married and file jointly with your spouse. In 2010, you participated in your employer's 401k plan and, with your spouse, earned $100,000. You made too much to deduct the maximum possible amount -- $5,000 -- but can deduct a portion of your contribution. According to IRS Worksheet 1-2 in Publication 590, you can deduct $2,250. If you want to contribute another $2,750, it will be taxed at your normal income tax rate.
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Benefits
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Before 2010, there weren't many benefits to making a nondeductible contribution to a traditional IRA. Because you don't get a tax break on either contributions or withdrawals, it is only slightly better than a normal investment account because you do not have to pay taxes on your annual earnings. However, 2010 rules make it possible for you to roll over amounts from a nondeductible traditional IRA to a Roth IRA regardless of your income. Before, you could not make a rollover if you earned more than $100,000. Roth IRAs offer a huge benefit over nondeductible traditional IRAs. While you owe income taxes on amounts you contribute to both types of accounts, withdrawals from Roth IRAs are tax free.
Roth IRA Features
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Like traditional IRAs, there are income limits associated with Roth IRAs. However, where traditional IRA income limits merely prevent you from deducting your contributions, Roth IRA income limits phase you out of contributing altogether. As of 2010, if you are married, filing jointly and make up to $167,000, you can contribute the full limit to a Roth IRA. If you and your spouse earn up to $177,000, you can contribute a portion of the limit. If you are married, filing jointly and earn more than $177,000, you cannot contribute to a Roth IRA.
Expert Insight
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When Congress got rid of the income cap for making a Roth IRA rollover, it also provided a loophole for high earners to skirt Roth IRA income limits. Now, you can contribute to a nondeductible traditional IRA, which has no income limits, and immediately roll the money into a Roth IRA. Though this process has the potential to create a lot of paperwork, it can provide you with significant tax savings after you retire.
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