Does it make sense to fund an individual retirement account (IRA) if you don't get a tax break for it?
Many people who are not eligible to fully fund a deductible IRA or Roth IRA 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 to a non-deductible IRA up to the tax filing deadline.
- Non-deductible IRAs lack some of the advantages of a traditional IRA or Roth IRA, but they come in handy if you want to sock away more for retirement than the current limits allow.
- Non-deductible contributions have eligibility rules and contribution limits.
- Savers must also keep track of their own contributions to non-deductible plans so that they can pay taxes on withdrawals accurately.
Understanding the Non-Deductible IRA
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.
For 2022, the maximum is $6,000, with an additional catch-up contribution of $1,000 if you are age 50 or over. For 2023, the limit increases to $6,500 but the catch-up amount remains $1,000.
You must begin taking required minimum distributions (RMDs) from your IRA during the year you turn 72 years old.
At one time, contributions were disallowed past the age of 70½. This is no longer the case, and you can continue making contributions at any age as 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, like a Roth IRA.
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, the following limits apply in 2022 and 2023:
- For a deductible IRA, filing as single or head of household eligibility in 2022 phases out between $68,000 and $78,000 in modified adjusted gross income (MAGI). (In 2023, the range increases to $73,000 to $83,000.) For married filing jointly, the phaseout is between $109,000 and $129,000 of MAGI. (For 2023, the range increases to $116,000 to $136,000.)
- For a Roth IRA, filing as single or head of household, 2022 eligibility phases out between $129,000 and $144,000 of MAGI. (For 2023, the range is $138,000 to $153,000.) For married filing jointly, the phaseout is between $204,000 and $214,000. (For 2023, the figures are $218,000 to $228,000.)
To help determine your eligibility, there is an IRA deduction worksheet in the instructions for IRS Form 1040.
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 appreciable 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.
One downside to non-deductible IRAs is record keeping. It is your responsibility to keep track of and claim any nondeductible 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 so that, upon the death of the IRA owner, the cost basis is not lost and transfers to the spouse or beneficiary.
Frequently Asked Questions
Is a Non-Deductible IRA the Same as a Roth IRA?
They are not taxed the same. In both types of accounts, after-tax money is contributed. That is, the investor pays the income tax due that year on the money that is deposited in the account.
However, a Roth IRA has a big advantage: When the money is withdrawn, presumably after the investor retires, no further taxes will be due either on the money deposited or the profits the money generates.
The profits earned in a non-deductible IRA will be taxable when it is withdrawn.
Even so, the non-deductible IRA is a good choice for a high-wage-earner who has topped off other retirement savings options, like a 401(k). The earnings in the account will not be taxed until it is withdrawn, so there's plenty of time for the balance to grow.
Does a Non-Deductible IRA Have Required Minimum Deductions (RMDs)?
Yes. A non-deductible IRA has the same RMDs as any other IRA. That is, you have to start taking a certain amount out per year starting at age 72. How much you have to take out each year depends upon your age and other factors.
The government wants its money. Even though you paid income tax on the principal, you haven't paid tax yet on the earnings.
How Much Can I Contribute to a Non-Deductible IRA?
The contribution limits are the same as for traditional IRAs. The numbers are revised every year. For 2022, the maximum allowable is $6,000, plus an additional $1,000 if you're age 50 or older. For 2023, the maximum is $6,500, and the catch-up contribution remains $1,000.
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, in this example, about 44% would be a tax-free return of your contribution.