What Is a Nondeductible IRA?

Many people contribute to an individual retirement account in order to qualify for a tax deduction. However, those who are not eligible to contribute to a tax-deductable traditional IRA or a Roth IRA may have the option of making nondeductible IRA deposits. A nondeductible IRA contribution is typically made by high earners looking for a way to save additional funds. Here’s how to make a nondeductible IRA contribution.

What Is a Nondeductible IRA?

The phrase “nondeductible IRA” does not refer to a separate retirement account. “The term designates contributions to a regular IRA that surpass limits set by the IRS,” says Christie Whitney, vice president of investment advice and director of planning at Rebalance in Palo Alto, California. Roth IRAs have modified adjusted gross income limits, and tax-deductable IRAs also have income limits when you or your spouse also have access to a workplace retirement plan, like a 401(k).

A nondeductible IRA contribution is not eligible for a tax deduction. As the name suggests, you’ll pay taxes on the amount you place into the account. However, the earnings within the account won’t be taxed until they are withdrawn from the account. “A nondeductible IRA is a case of half a loaf being better than none,” Whitney says. “You don’t get the immediate tax break on your income taxes in the years you contribute, but the invested cash does grow tax-free in the account.”

In 2021, you’ll be able to contribute up to $6,000 to an IRA. If you are age 50 or older, the limit is $7,000. Starting at age 72 you will need to take required minimum distributions from the traditional IRA account. “When withdrawals are made, only the gain from the account is taxable as income and the original contributions are not taxed,” says Jeff Mattonelli, a financial advisor at Van Leeuwen & Company in Princeton, New Jersey.

[Read: IRA Contribution Limits for 2021.]

Who Is Eligible for a Nondeductible IRA

High earners may not qualify to contribute to other retirement accounts such as a deductible IRA or a Roth IRA. “The ability to deduct IRA contributions is determined by income phase-outs, tax filing status and if you are covered by a workplace retirement plan,” says Brian Fry, a certified financial planner and founder of Safe Landing Financial in Austin, Texas. For instance, a married couple that files taxes jointly cannot contribute to a Roth IRA if their income reaches $208,000 or more during a year. Those filing as a single taxpayer who make $140,000 or more also won’t be able to contribute to a Roth IRA. If you have a 401(k) at work and your salary surpasses $76,000, or $125,000 for couples if both spouses have a 401(k), you may not be able to deduct your contributions to a traditional IRA. Those who don’t qualify for a traditional IRA or Roth IRA may choose to make nondeductible IRA contributions.

[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]

How a Nondeductible IRA Differs From Other Retirement Accounts

With a traditional IRA, you can deduct the contributions you make to the account from your taxable income. The funds may earn interest within the account, and then withdrawals will be subject to taxes. Withdrawals from traditional IRAs are required starting at age 72. “With a nondeductible IRA, part of the withdrawal could be considered income taxable gains and part of the withdrawal would be considered return of principal,” Mattonelli says. You won’t owe income tax on the nondeductible amount you contributed to the account, only the investment gains.

Roth IRA contributions are made with after-tax dollars and withdrawals in retirement will not be subject to taxes. To be eligible for a Roth IRA, your income can’t exceed certain IRS limits. Those who earn too much to contribute directly to a Roth IRA might instead make nondeductible IRA contributions. Often called a backdoor Roth IRA, you can make a nondeductible IRA contribution and then convert that contribution to a Roth IRA. “Once in a Roth IRA, funds can grow tax-free for the rest of your life with no required minimum distributions,” Fry says.

If you opt to make a nondeductible IRA contribution, and then convert the funds to a Roth IRA, you may need to pay taxes on part of the amount. “If you make both deductible and nondeductible contributions to an IRA, then convert, you will owe taxes on the portion you previously deducted,” Whitney says.

[READ: How to Make a Last-Minute IRA Contribution.]

What to Consider Before Using a Nondeductible IRA

While a nondeductible IRA can provide benefits, it’s important to carefully document the funds contributed and taxes paid. “It’s very important to keep careful records of your IRA contributions, both deductible and nondeductible,” Whitney says. “If you want maximum flexibility later on, immaculate records will help your financial advisor and tax preparer make sure you stay on the right side of the IRS.” When you make a nondeductible contribution, you’ll need to file form 8606 with the IRS. “If you don’t file form 8606, the IRS will charge taxes down the road and you will pay taxes twice,” Fry says.

When evaluating a nondeductible IRA, you’ll want to review your income, tax filing status and other retirement savings options. “Depending on one’s unique situation, a nondeductible IRA contribution can be an incredibly valuable resource for financial planning,” Fry says. “If you have no other pre-tax IRA assets, then the best use of a nondeductible IRA contribution is to apply the backdoor Roth IRA strategy.”

More from U.S. News

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What Is a Nondeductible IRA? originally appeared on usnews.com

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