What Is a Nondeductible IRA?

IRAs offer tax advantages.

IRAs, or individual retirement accounts, were created by the federal government to encourage people to save money for retirement. These accounts offer different tax breaks depending on the type of account that is chosen. For example, traditional IRAs usually allow contributions to be deducted from your taxes, and Roth IRAs let withdrawals be taken tax-free at retirement.

Misconceptions

A nondeductible IRA is not a type of IRA. Instead, a nondeductible IRA refers to a traditional IRA that has contributions that you were not allowed to deduct from your taxes when you made the contribution. You do not have to set up a separate IRA to receive these contributions. Instead, your financial records will show how much money you contributed to the account that was not deductible from your taxes.

History

When the Employee Retirement Income Security Act, which created IRAs, was passed in 1974, only people who were not covered by an employer plan were eligible to contribute to IRAs. It was not until 1981, with the passage of the Economic Recovery Tax Act, that individuals covered under an employer plan were allowed to contribute. However, in 1986, the Tax Reform Act phased out the ability to deduct IRA contributions for people covered by employer plans based on their income level, which caused some contributions to traditional IRAs to be nondeductible.

Features

The deduction of your traditional IRA contribution depends on whether you and, if applicable, your spouse are covered by an employer-sponsored retirement plan. If you have no employer-sponsored plan, your contribution is always deductible. If you are covered, your modified adjusted gross income must be below the limit for your filing status to make a deductible contribution. These limits can adjust annually for inflation. For 2010, your contribution is nondeductible if you are covered and your modified adjusted gross income is over $66,000 if you are single, $10,000 if you are married filing separately or $109,000 if you are married filing jointly. If only your spouse is covered, your contribution is nondeductible if your modified adjusted gross income exceeds $10,000 if you are married filing separately or $177,000 if you are married filing jointly.

Effects

When you make a nondeductible contribution, you are not allowed to deduct it from your taxable income. The money does grow tax-free in the account until you decide to take a withdrawal. Typically, the entire amount of a withdrawal from a traditional IRA is taxable. However, when taking a withdrawal from a traditional IRA with nondeductible contributions, the percentage of the withdrawal equal to the percentage of the IRA made up of nondeductible contributions is tax-free. For example, if you had $9,000 of nondeductible contributions in your traditional IRA and the IRA's total value was $12,000, 75 percent of your withdrawal would be tax-free.

Considerations

In 2010, the government removed any income restrictions on who could convert money from a traditional IRA to a Roth IRA. When you convert money from a traditional IRA to a Roth IRA, you must pay taxes on the amount of the conversion, not including nondeductible contributions. For example, if you wanted to convert your $20,000 traditional IRA with $12,000 in nondeductible IRA contributions to a Roth IRA, you would only have to pay taxes on $8,000. Then, when you take a qualified withdrawal from the Roth IRA, the entire amount comes out tax-free.

References

• Internal Revenue Service: Publication 590
• Internal Revenue Service: Effect of Modified AGI on Deductible Contributions If You Are Covered by a Retirement Plan at Work
• Internal Revenue Service: Effect of Modified AGI on Deductible Contributions if You are Not Covered by a Retirement Plan at Work
• Congressional Budget Office: Legislative History of IRAs
• Moneyzine: 2010 Roth IRA Conversions