Contributions to a traditional IRA are supposed to be tax deductible. But that's not true for everyone. When you participate in a qualified retirement plan like a 401(k) and have income above a threshold amount set annually for your filing status, the contributions you make to your traditional IRA are not deductible.
But even when IRA contributions are nondeductible, there are good reasons to make them anyway: They increase your retirement savings and earnings on these contributions are tax deferred. (Note: The annual contribution limit to an IRA is the same whether you make deductible contributions or after-tax, i.e. nondeductible, contributions. For more on income thresholds and contribution limits, see IRA Contribution Limits: Eligibility and Deadlines.)
Of course, contributions to a Roth IRA are always made with post-tax income, if you qualify to make them. And distributions from a Roth IRA are always tax free. But if you're over certain income levels, you can't have a Roth (see Too Rich for a Roth? Do This).
Where taxes come in for a traditional IRA is when you start taking distributions from your account. Distributions from a traditional IRA are generally taxed at your individual income tax rate. But when that IRA was built up with non-deductible contributions, you don't owe tax on all your distributions, which complicates tax reporting. The goal is to make sure you are paying no more tax than necessary. Handling this requires you to keep track of your nondeductible contributions.
Why Keep Track of Your Contribution Balance
When you make deductible contributions to an IRA, all amounts in the account are going to be taxed when you take them out as a distribution or convert them to a Roth IRA. But when you make nondeductible contributions to an IRA, the computations for these actions become more complicated so that you aren’t taxed again on your after-tax dollars. In order to get it right, you must keep good records of what you contributed to your IRA on an after-tax basis.
When you make a nondeductible IRA contribution, report it on Form 8606, Nondeductible IRAs. Entering any nondeductible contribution you make for the current year, added to your nondeductible contributions in prior years (minus adjustments for distributions) gives you the total basis in traditional IRAs. This information helps you figure the tax on distributions and conversions.
Be sure to retain copies of Form 8606 so you’ll have basis information for the future. Don’t assume that your IRA custodian or trustee will track this information for you.
How to Figure Tax on Distributions
If you’ve made nondeductible IRA contributions, part of any distribution is tax free; the balance is taxable. Here's a key point: An allocation is required even if you are taking a distribution from an IRA to which only nondeductible contributions were made. This allocation is figured on Form 8606.
When you have both types of traditional IRAs (those with tax-deductible contributions and those with after-tax ones), figuring out how much of your distribution is taxable is a complicated process. Read the following explanation carefully; you may benefit from the help of an accountant or other experienced tax preparer.
You cannot designate that your traditional IRA withdrawals are coming from your after-tax contributions. The required allocation takes into account all contributions and earnings. More specifically, divide total nondeductible contributions by the year plus the value of all IRA accounts (including SEP-IRAs and SIMPLE-IRAs) as of the end of the year of the distribution (adding any distributions taken during the year).
For example, if you made $10,000 in after-tax contributions over the years, your IRAs and your account balance plus the distribution is $100,000 ($90,000 account balance plus $10,000 distribution), your percentage is 10%. This percentage is the tax-free percentage of the IRA distribution. Multiply the distribution for the year ($10,000) by this percentage to know what is tax free ($1,000); the balance ($9,000) is taxable. As you can see, even though the distribution equals your after-tax contributions, you can’t avoid income tax on the distribution.
If you take a distribution before age 59½, you’re subject to a 10% penalty only on the taxable portion of the distribution (assuming no penalty exception applies). The 10% penalty does not apply to the tax-free portion of the distribution.
Losses. If you have a loss on the investments in your account, you can recognize the loss, but only when all of the funds in your IRA have been distributed to you. The amount of the loss is the excess of the amount distributed minus any remaining basis from nondeductible contributions. For example, you made after-tax contributions to an IRA of $10,000 (assume no deductible contributions), and the account is now worth $4,000. If you fully distribute the funds, you have a $6,000 loss. The loss is taken as a miscellaneous itemized deduction on Schedule A of Form 1040 (you must itemize to get any tax benefit from the loss).
How to Figure Conversions to Roth IRAs
When you convert some or all of a traditional IRA to a Roth IRA, and you’ve made after-tax contributions to any IRA, again you can’t designate which funds (pre-tax or after-tax) are being converted in order to minimize tax on the conversion. You have to run through the same computation you used for withdrawals. You figure the percentage of your after-tax contributions to the total value of your IRA accounts and apply it to the amount you convert. (For more on Roth conversions, see Converting Traditional IRA Savings to a Roth IRA.)
The Bottom Line
There are some good reasons to make nondeductible IRA contributions, but doing so complicates your tax life. Be sure to keep records so you won’t pay tax on these contributions when you take distributions or make Roth IRA conversions. And if you're not a math genius, consider having a tax professional figure out what you owe.