An Individual Retirement Account, IRA, is an investment account bestowed with certain tax advantages by the Internal Revenue Service, IRS. A nondeductible IRA is one that contains contributions made on an after-tax basis, rather than the pre-tax contributions often associated with IRA. Nondeductible contributions can be made to a traditional IRA or a Roth IRA, which is a special type of IRA introduced in 1998.
IRA Contribution Limits
Every year, the IRS publishes the contribution limit for IRAs in IRS Publication 590. For 2010, this limit is the lesser of $5,000 or the amount of your taxable compensation, as defined by the IRS. If you are age 60 or older, you can contribute an additional $1,000 to your IRA. This limit applies to Roth IRAs as well as both deductible and nondeductible contributions to a traditional IRA. The amount is not cumulative, meaning if you are younger than 50 and make a $4,000 deductible contribution to your traditional IRA, you can only contribute an additional $1,000 to another IRA.
Roth IRAs
A Roth IRA is funded with after-tax dollars, thus all Roth contributions are considered nondeductible. Not everyone is allowed to contribute to a Roth IRA. For 2010, if your modified adjusted gross income is $120,000 or more as a single filer, or $176,000 or more as a married taxpayer filing jointly, you cannot contribute to a Roth IRA. Many high-income taxpayers that cannot contribute to a Roth IRA make a nondeductible contribution to their traditional IRA.
Annual Taxation
For all IRA accounts, you do not have to pay current income tax on the earnings growth and interest paid into the account. For example, if you earn $10,000 in taxable interest in an IRA, you do not have to include this amount when you file your taxes, as you would if you earned the money in a regular taxable investment account.
Taxation of Withdrawals
All distributions from traditional deductible IRAs are fully taxable at ordinary income tax rates, but for nondeductible IRAs, only the earnings portion of your withdrawal is taxable. Calculating the amount of taxable earnings in a nondeductible IRA can be extremely complicated, and you may want to consider the services of a tax adviser to help you. For Roth IRAs, all distributions are tax-free, with no calculation required. The only exceptions in a Roth IRA are withdrawals taken within five years of the establishment of the account, in which case the earnings amount of the distribution are fully taxable, and the IRS imposes an additional 10 percent early withdrawal penalty.
Required Minimum Distributions
The IRS mandates that you begin taking distributions from your traditional IRA once you reach age 70 1/2, regardless of whether the IRA is deductible or nondeductible. Roth IRAs carry no such requirement.
Required Tax Forms
When you make a nondeductible contribution to a traditional IRA, you must fill out Form 8606 and file it with the IRS. Using this form will help you avoid being taxed twice on the same money, as it documents that amount of after-tax money already contributed to your IRA.
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