• Michael DiBartolomeo

How Are Non-deductible IRA Contributions Taxed When Withdrawn

Updated: Dec 15, 2020

There are various retirement savings account types available, and it's possible to contribute to them outside of an employer-backed retirement plan. The nondeductible IRA is a possibility, but there are also Roth IRAs and the Traditional, or Contributory IRA. Though they are all different, they do have a few similarities, including the tax owed and whether or not the funds grow tax-free:

  • Each option allows the money to grow tax-free, which means there aren't any dividends taxes or capital gains taxes owed. However, it must remain invested in that particular account.

  • A person gets penalized if they make withdrawals before they are 59.5 years old in most circumstances. Generally, the penalty is 10 percent on the distribution's taxable portion.

  • People are allowed to add to the IRA, but only up to the annual limits. It's only possible to contribute with earned income from wages, salaries, and self-employment incomes. These incomes are calculated after all tax has been taken out.

Though there are a few similarities, there are many significant differences between simple IRAs, a Roth IRA, and a nondeductible IRA. These include who can add money and the benefits of investing in them. For example, some of them can have funds taken out, which are tax-free, or where the person pays less tax to remove them.


Non-deductible IRA

What's a Nondeductible IRA?


The nondeductible IRA is a retirement savings account. It's possible to add money from after-tax dollars, and it ensures that the total funds grow for life after one retires without anyone having to pay any tax on it until the gains are removed.


Primarily, the difference between this and a traditional or Roth account is that people can make nondeductible contributions regardless of how much they make. On the other hand, a Roth or traditional IRA are subjected to much stricter income limits. Once it hits a particular level, contribution eligibility may start to phase out and ends up disappearing completely. That never happens for nondeductible contributions.


Though the nondeductible IRA isn't quite as restrictive as others for eligibility concerns, there aren't the same tax advantages as with the other funds. Still, people can add to one to help their money grow without having to owe capital gains. Similarly, people may choose to utilize the nondeductible IRA to convert the invested funds into Roth IRAs at some point. It may be important to understand, though, that there is tax paid to convert.


Important Things to Know about Nondeductible IRAs


Contribution Limits

Nondeductible IRA contributions are subject to the same limits as other IRA accounts. However, the nondeductible IRA contributions are generally made with after-tax dollars. The contribution to a 401(k), Roth, or traditional IRA are deducted the same year that they're made. It's important to file form 8606 with the tax return from the IRS when contributing to the nondeductible account.


Withdrawing Contributions (Is It Possible)?

Non-deductible contributions to the IRA can be taken out without having to pay taxes on the funds, though. In a sense, people could get taxed twice on such contributions otherwise. However, it is important to tell the IRS that after-tax funds were contributed. To do that, any non-deductible contributions must be reported, and the person should file form 8606 with the tax return and get it to the IRS each year. This tax form is important to ensure that the owner of the account isn't taxed on contributed funds twice when it's removed for retirement purposes.


It's recommended that people take advantage of the option to convert to other IRA account options.


Withdrawing Gains

Withdrawals made on investment gains are taxed at the traditional income tax rate. Typically, IRA contributions from Nondeductible IRAs don't provide the same tax-free withdrawals on the earnings as other options do. Again to withdraw gains, it's important to let the IRS know what is being done. File form 8606 on the income tax return to avoid extra taxes being taken out.


Generally, filing tax form 8606 with the return is easy, but a personal finance professional can help this happen quickly and without issue.


Should Someone Use a Nondeductible IRA?


Keep in mind that a non-deductible IRA should only be used by those who can't qualify for other retirement savings accounts. Since it doesn't include the same advantages and has penalties for withdrawals on any taxable parts of the distribution, it's seen as a worse choice. However, it might be the only option, depending on the investments made, contribution to the account, and other considerations.


The taxable portion of the income is sometimes called the adjusted gross income. This includes any business amounts, wages, investing income, and other sources. It's easy to calculate this number.


Once that is done, it would be best to subtract any taxable deduction amounts. This includes the deductible part of the self-employment tax, any nondeductible contribution amounts, contributions and distributions from health savings, and any deductible interest from student loans. The number shown is now the new balance.


It's important to add back in the deductions from tax-exempt amounts and any tax-exempt interest income received. This total amount is called the MAGI (Modified Adjusted Gross Income). It's what the IRS uses to tell if there's a need for a Roth or traditional IRA.


That total quantity shown determines if someone is eligible to participate in some of the better IRA options. It's important to check with a personal finance professional to decide on the limits for a particular year. If that person or their spouse is eligible for any workplace retiring plan and the MAGI is high, neither person qualifies to make deductible contributions to a regular IRA. A nondeductible contribution is still possible based on the plan, total taxable amounts, and other considerations. Remember, it is essential to get the IRS tax form 8606 and file it at the right time for any total distributions and IRA contribution amounts made.


Typically, incomes over a particular size makes a person ineligible to add money to the balance of a Roth account at all. It is best to have someone with years of experience help to figure out which option would be best. No one wants to pay extra to plan for their future.


Should You Add to a Non-Deductible IRA

Should People Add to a Nondeductible IRA?


The need to work means that a person must spend many years building up the funds to live on when they retire. Typically, they file their tax returns throughout the years to show how much they've made and get some of that balance back because of everything they pay into it while working.


If a person isn't eligible for a tax-advantaged IRA because of their income or that of their spouse, nondeductible contributions are still a possibility and provide a more convenient way to save funds and grow the account. It's tax-free until the earnings are withdrawn for the future.


It may be difficult to balance everything, and people must remember that they cannot make a withdrawal on the IRA without significant penalties.


Still, it's possible to use the nondeductible contributions and add funds to the Roth fund, even if the amount made is too high to do so otherwise. This creates a balance that may ensure that a person gets more favorable tax rules that are associated with the Roth account. Remember, Roth account options are always tax-free and ensure that the funds grow. Withdrawal of a part of these funds are possible and have fewer penalties.


Any nondeductible contributions must be accompanied with the IRS form 8606. This may help when filing the tax return at the end of the year. Though it's not tax-free, it does prevent the owner of the account from having to pay more tax on what is removed.


Remember, though: Nondeductible IRAs don't provide the same tax benefits as other account options. It's essential to file all IRS forms each year to declare the nondeductible contribution amounts, which prevent a person from getting a double tax hit when they go to retire. Withdrawal at this point is not-tax-free. The IRS is going to take what it owes for all the years it didn't get anything.


Since it is possible to make a withdrawal before retiring, this amount must be put on the income tax return by filing form 8606.


Distributions


The need to make a contribution to the non-deductible IRA means that a person has to use Form 8606 when filing their federal tax return. The form documents the after-tax nondeductible contributions, which is essential once a person starts taking distributions.


It's allowed to take any amount out of the IRA without penalties between the ages of 59.5 and 72. At age 72, the IRA requires that the person puts the value of all their IRAs together and starts taking distributions from the traditional ones.


Those who made nondeductible contributions have portions that can have tax attached to them and some that don't.


Are Nondeductible IRA Contributions Taxed When Converted to a Roth IRA?


If the nondeductible contributions are converted to a Roth account, tax is likely to be owed. There is no need to do this, and it isn't a requirement. The amount of tax owed varies, but it often focuses on the gains. No tax is owed on the portion that isn't taxable.


Remember, there is a need to file Form 8606 when contributing to the funds or converting them. This may need to be done each year, depending on the situation of the person. Talk to a financial advisor or utilize the IRA deduction worksheet on the Form 1040.


Conclusion


Owning an IRA is essential to ensure that a person can retire safely. They have paid tax throughout the years through work and pay tax through various situations in their lives. It is important to select the right IRA, but sometimes this is done for the person because they aren't eligible for other options.


Regardless, it's essential that a person don't overpay on tax because of the IRA they own.


Contact several different experienced Pittsburgh financial advisors to discuss a non-deductible IRA.