Does it make sense to fund a nondeductible individual retirement account (IRA)? Many people who are not eligible to fully fund a deductible IRA and/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.
- Nondeductible 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.
- Nondeductible contributions have their own eligibility rules and contribution limits that must be observed.
- Savers must also keep track of their own contributions to nondeductible plans, so that they can be taxed appropriately upon retirement withdrawals.
Unlike a traditional IRA, which is tax deductible, nondeductible 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 2019 and 2020 the limit is $6,000, with an additional catch-up contribution of $1,000 if you are age 50 or over. You can continue making contributions until the year in which you reach age 72 when required minimum distributions (RMDs) must begin. The RMD age was previously 70-1/2 but was raised to 72 following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act.
Contributions can be allocated across different kinds of IRAs. For example, you could make additions to a tax-deductible, nondeductible, and/or Roth IRA in a given tax year, as long the combined contributions do not exceed the limit. And, unlike a Roth IRA, deductible and nondeductible IRA contributions can be commingled in the same account.
Nondeductible contributions to an IRA don’t provide an immediate tax benefit because they are made with after-tax dollars.
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 2019:
- For a deductible IRA, filing as single or head of household eligibility phases out between $65,000 and $75,000 of modified adjusted gross income (MAGI) for 2020 ($64,000 and $74,000 for 2019). For married filing jointly the phaseout is between $104,000 and $124,000 of MAGI ($103,000 and $123,000 for 2019), and for married filing single the phaseout is $10,000 of MAGI.
- For a Roth IRA, filing as single or head of household eligibility phases out between $124,000 and $139,000 of MAGI ($122,000 and $137,000). For married filing jointly the phaseout is between $196,000 and $206,000 of MAGI ($193,000 and $203,000), and for married filing single the phaseout is $10,000 of MAGI.
To help determine your eligibility, there is an IRA deduction worksheet in the instructions for IRS Form 1040.
For any year in which you do make a contribution to a nondeductible 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 nondeductible IRAs and begin taking distributions from your traditional (but not Roth) IRAs.
If you made nondeductible 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 nondeductible 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 nondeductible 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 and is based on the December 31 value of all your IRA accounts. For investors who have more than one IRA account, the distribution can be drawn from each account or just one.
One downside to nondeductible IRAs is the 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, as upon the death of the IRA owner the cost basis is not lost and does transfer to the spouse or beneficiary.
The Bottom Line
Annual contributions to a nondeductible IRA are limited, but over time they can really 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.