Should You Contribute to a Non-Deductible IRA?

If you have extra money to invest in retirement, it may be the answer

Does it make sense to fund a non-deductible individual retirement account (IRA)? Many people who are not eligible to fully fund a deductible IRA or Roth IRA often overlook this easy opportunity to sock away additional dollars for retirement where they can grow tax-free. And unlike a 401(k) or other salary deferral plan, you can make contributions up through the April 15 tax filing deadline.

Key Takeaways

  • Non-deductible IRAs lack many of the advantages of a traditional IRA or Roth IRA, but they come in handy when you want to sock away more for retirement than the current limits allow.
  • Non-deductible contributions have their own eligibility rules and contribution limits that must be observed.
  • Savers must also keep track of their own contributions to non-deductible plans so that they can be taxed appropriately upon retirement withdrawals.

Non-Deductible IRAs

Unlike a traditional IRA, which is tax-deductible, non-deductible IRA contributions are made with after-tax dollars and provide no immediate tax benefit. In a given tax year, as long as you or your spouse have enough earned or self-employment income, you can each contribute to an IRA.

On March 17, 2021, the Internal Revenue Service (IRS) announced that the federal income tax filing due date for all taxpayers for the 2020 tax year would automatically be extended from April 15, 2021, to May 17, 2021. This pushed other tax-related deadlines back as well. For example, the deadline to make IRA contributions is usually April 15, but taxpayers were given until May 17, 2021, to file. And taxpayers impacted by the 2021 winter storms in Texas were given by June 15, 2021, to file various individual and business tax returns, make tax payments, and make 2020 IRA contributions. (The IRS's extension for victims of the 2021 winter storms was announced on Feb. 22, 2021.)

For 2021 and 2022, the limit is $6,000, with an additional catch-up contribution of $1,000 if you are age 50 or over.

You must begin taking required minimum distributions (RMDs) from your IRA during the year you turn 72 years old. The RMD age was previously 70½ years old but was raised to age 72 following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act.

Before the SECRE Act, IRA contributions were disallowed past the age of 70½. This is no longer the case, and you can continue making contributions at any age, so long as you meet the IRS criteria.

Contributions can be allocated across different kinds of IRAs. For example, you could make additions to a tax-deductible, non-deductible, or Roth IRA in a given tax year, as long as the combined contributions do not exceed the limit. And unlike a Roth IRA, deductible and non-deductible IRA contributions can be commingled in the same account.

Non-deductible contributions to an IRA don’t provide an immediate tax benefit because they are made with after-tax dollars.

Eligibility

Your ability to fund different kinds of IRAs is subject to restrictions based on your income, tax filing status, and eligibility to participate in an employer-sponsored retirement plan, even if no contributions have been made to the plan in a given tax year.

If you and your spouse do not have an employer plan at work, there are no restrictions on fully funding a deductible IRA. However, if either you or your spouse is eligible to participate in an employer-sponsored plan, then the following limits apply in 2021:

  • For a deductible IRA, filing as single or head of household eligibility phases out between $66,000 and $76,000 of modified adjusted gross income (MAGI) for 2021. In 2022 it goes up to $68,000 and $78,000. For married filing jointly, the phaseout is between $105,000 and $125,000 of MAGI, and the phaseout for married filing single is $10,000 of MAGI. (In 2022, these figures go up to $109,000 and $129,000.)
  • For a Roth IRA, filing as single or head of household eligibility phases out between $125,000 and $140,000 of MAGI. For married filing jointly, the phaseout is between $198,000 and $208,000 of MAGI, and the phaseout for married filing single is $10,000 of MAGI.

To help determine your eligibility, there is an IRA deduction worksheet in the instructions for IRS Form 1040.

Distributions

For any year you contribute to a non-deductible IRA, you need to include IRS Form 8606 in your federal tax return. This form documents your after-tax contribution, which is important once you begin taking distributions.

Between ages 59½ and 72, you are free to take any amount out of your IRA without a penalty, but you are not required to do so. Once you reach age 72, the IRS requires you to aggregate the value of all your deductible and non-deductible IRAs and begin taking distributions from your traditional (but not Roth) IRAs.

If you made non-deductible contributions, then any distribution contains both a taxable and a nontaxable portion. The nontaxable portion is based on your cumulative after-tax contributions, and the taxable portion is based on the money those contributions earned over time. For example, over the years, you contributed $50,000 to a non-deductible IRA, and by age 72, the account grew to $75,000. Roughly 33% ($25,000) of the account value would be appreciation and taxable.

The actual amount of your RMD is determined by an IRS table based on your age. Your IRA custodian may send you a statement of how much you need to take out, but this work is best done by a tax advisor who can also help you figure out how much of your RMD is taxable if it includes non-deductible contributions. It's also important to keep records of your contributions, as noted below. The computation to determine the taxable and nontaxable ratio needs to be recalculated every year based on the December 31 value of all your IRA accounts. For investors with more than one IRA account, the distribution can be drawn from each account or just one.

Documentation

One downside to non-deductible IRAs is record keeping. It is your responsibility to keep track of and claim any non-deductible contributions. The IRS recommends keeping your 1040 and 8606 forms, as well as the Form 5498 that you receive each year from the IRA custodian to document your contributions and distributions. This is important, as, upon the death of the IRA owner, the cost basis is not lost and transfers to the spouse or beneficiary.

The Bottom Line

Annual contributions to a non-deductible IRA are limited, but over time they can add up. For instance, if you contributed $6,500 a year for 10 years, beginning at age 50 and then retired at age 60, assuming a 6% rate of return, your contributions could grow to more than $150,000 by age 70. And once you start taking distributions, about 44% would be a tax-free return of your contribution.

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