Tax Consequences of a Nondeductible IRA Distribution

by Michael Keenan

A nondeductible individual retirement account (IRA) refers to a traditional IRA containing nondeductible contributions. Knowing how to figure the tax implications of a distribution from a traditional IRA containing nondeductible contributions helps you budget how much you need to withdraw to cover the taxes you owe when you file your return.

Nondeductible IRA Function

Typically, people contribute to a traditional IRA to take advantage of the tax deduction for the contributions. However, if you are covered by an employer plan and make too much money, or if you simply elect to make a nondeductible contribution, you do not deduct the contribution on your taxes. The money still grows tax-free, but when you take a withdrawal, the part of your distribution comprised of those nondeductible contributions comes out tax-free because you did not claim a tax deduction for them.

Figuring the Taxable Portion

To figure the taxable portion of your nondeductible IRA, you first have to figure out how much you have in the account from nondeductible contributions. Then, divide the amount of nondeductible contributions by the account total to find the portion of your nondeductible IRA distribution that comes out tax-free. The remaining portion of your nondeductible IRA distribution is subject to income taxes and penalties.

Early Distributions from Nondeductible IRAs

If you take an early distribution from your nondeductible IRA, you must pay a 10 percent early withdrawal penalty. However, the penalty only affects the taxable portion of the distribution. For example, if you take a $3,700 early distribution and only $2,000 is taxable, the penalty would only be $200 rather than $370 if the entire distribution was subject to the early withdrawal penalty. Like any other IRA distribution, you can avoid the early withdrawal penalty if you have a qualifying exception such as college expenses, a permanent disability or medical expenses above 7.5 percent of your adjusted gross income.

Tax Forms to File for a Nondeductible IRA Distribution

When you take a distribution from a nondeductible IRA, you first complete Form 8606, Part I. This documents for the IRS how you figured the taxable and nontaxable portion of your IRA distribution. If you have not turned 59 1/2 years old, you must complete Form 5329 because your distribution is not qualified and therefore you owe a penalty. Finally, file your tax return with Form 1040 and report the nontaxable portion, the taxable portion and, if applicable, the early withdrawal penalty.