Tax on a Nondeductible IRA

by Mark Kennan

A nondeductible contribution to a traditional IRA alters the way that the account is taxed, both when you deposit the money in the account and when you take distributions. If you do not qualify for a Roth IRA, making a nondeductible contribution to a traditional IRA still benefits you because of the tax-sheltered growth and, if you expect to fall in a higher income tax bracket at retirement, you save money because you do not have to pay income taxes when you remove the nondeductible contribution.

Tax When Contributing

When you make a nondeductible contribution to your traditional IRA, you have to report the contribution on your taxes with Form 8606 so that the IRS can keep track of how much you have contributed. However, you do not get to claim an income tax deduction for your contribution. Instead, the money you contribute still counts as taxable income and is taxed at your marginal tax rate.

Taxes on Distributions

When you take a distribution from a traditional IRA containing nondeductible contributions, the IRS divides the amount of the distribution between nondeductible contributions and the remainder of the account. Because you already included the nondeductible contributions as taxable income in the year you made the contribution, the IRS does not require you to pay tax a second time when you remove those contributions. However, you did not pay taxes on any deductible contributions or earnings in the account, so those count as taxable income.

Calculating the Tax-Free Portion of Your Withdrawal

To figure the tax-free and taxable portions of a withdrawal from a traditional IRA with nondeductible contributions, you need to know the total nondeductible contributions in the account and the value of the account at the time you take your distribution. Divide the nondeductible contributions by the total value to find the tax-free portion of the distribution as a percentage. For example, if you have $60,000 in nondeductible contributions and your traditional IRA has a total value of $300,000, 20 percent of your distribution is tax-free.

Early Distribution Penalties

When you take an early distribution from a traditional IRA containing nondeductible contributions, the early withdrawal penalty only applies to the taxable portion of the distribution. This distinction can make a big difference when figuring your 10 percent early withdrawal penalty, especially if most of your account's value comes from nondeductible contributions. For example, if half of your traditional IRA's value comes from nondeductible contributions and you take a $12,000 early withdrawal, only $6,000 would be subject to the early withdrawal penalty, saving you $600 in early withdrawal penalties on your taxes.

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