A nondeductible individual retirement account (IRA) is not a unique type of IRA, but rather a reference to a traditional IRA that contains nondeductible contributions. People with traditional IRAs containing nondeductible contributions often convert them to Roth IRAs so that they can not only take the contributions out tax-free, but also all the earnings.
Nondeductible Contributions Defined
Many people make contributions to their traditional IRA because they can deduct the contributions on their income taxes, but some people either cannot or elect not to deduct them and therefore make nondeductible contributions. If your modified adjusted gross income (MAGI) is too high and you have an employer plan, the IRS still lets you contribute, but you cannot deduct your contributions. Other people elect to make nondeductible contributions with the intention of converting the account to a Roth IRA.
Taxable Portion of the Conversion
If you decide to convert your entire traditional IRA containing nondeductible contributions to a Roth IRA, you do not have to include nondeductible IRA contributions in the taxable portion of the distribution. If you convert the entire account, figuring the taxable and nontaxable portions is easy: subtract the total nondeductible contributions from the account value to find the taxable portion. However, if you only convert part, the IRS does not let you pick which parts of the account you want. Instead, your conversion includes nondeductible contributions and the remainder of the account based on the percentages in your traditional IRA as a whole. For example, if 64 percent of your traditional IRA is nondeductible contributions, then 64 percent of your conversion is tax-free.
Conversion Tax Rate
The taxable portion of your traditional IRA with nondeductible contributions conversion to a Roth IRA must be included as part of your taxable income for the year. For example, if you have a $50,000 in other taxable income and $15,000 of your conversion is taxable, your taxable income for the year increases to $65,000. This extra income from your conversion may even push you into a higher income tax bracket, but only the amount falling in the bracket is taxed at the higher rate. However, depending on your financial circumstances, getting pushed into the higher bracket may eliminate much of the reason to convert in the first place.
Paying Your Taxes
As long as you complete the conversion without taking out any money, you do not owe an early withdrawal penalty. If, however, you take out money from your traditional IRA with nondeductible contributions and you are under 59 1/2 years old, you have to pay an early withdrawal penalty on the taxable portion, even if you only take the money out to pay the taxes you owe on your conversion. Therefore, if at all possible, try to find another source of funds to pay the conversion tax. Also, consider spreading the conversion out over a few years so that you can keep your income in a lower tax bracket and only have to pay a smaller chunk of the tax each year.