Although contributing to a traditional IRA usually allows you to deduct the amount you contribute from your taxes, there are some cases in which you cannot make deductions. Nondeductible traditional IRA contributions are handled differently than deductible contributions. You will need to complete additional paperwork each year you make nondeductible contributions to prove to the IRS that you already paid tax on that amount.
Limits on Deductible Contributions
Your income and whether or not you are covered by a retirement plan at work determine the amount of money you can claim as a tax deduction from an IRA contribution. As of 2011, you can contribute $5,000 per year or $6,000 if you are over 50 to your IRA. If you earn less than $56,000, are single and have a retirement plan at your job, you can still deduct the full amount of your traditional IRA contribution. If you earn more than $66,000, are single and have a plan at work, you cannot deduct any of your contribution. Single people who are covered by a retirement plan at work and earn between $56,000 and $66,000 as of 2011 can deduct part of their contribution.
Roth vs. Nondeductible IRA
Taxes are prepaid on both a Roth and a nondeductible IRA. You do not need to complete additional paperwork when you contribute to a Roth IRA, though. You also cannot earn more than $120,000, if you are single, to contribute to a Roth, or $177,000 if you are married and file jointly, as of 2011. The amount you earn in a Roth IRA is tax-free, while you will need to pay taxes on the amount a nondeductible IRA earns.
Each year that you make nondeductible contributions to your traditional IRA, you will have to complete Form 8606 and include it with your tax return. Form 8606 reports your nondeductible contributions to an IRA as well as any distributions you take from a Roth IRA and any rollovers from a 401(k), 403(b) or traditional IRA you may have done during the year. The form is required every year you make a nondeductible contribution. If you don't complete it, you may have to pay a $50 fine.
If you have a traditional IRA that consists of a mix of deductible and nondeductible amounts, you will not pay tax on the nondeductible amounts when it is time to take distributions, but will owe tax on the earnings and your deductible amounts. The difference between your deductible and nondeductible amounts is known as the basis. If you have an IRA of $40,000, $30,000 of which are from deductible contributions and $10,000 of which are nondeductible contributions, the $10,000 is the basis. When you take a distribution, you will need to divide the total amount of your IRA by the basis. Multiply the amount of your distribution by the result to determine how much of your distribution is tax-free.
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