If you don’t qualify for a traditional IRA deduction, you may still be able to contribute to an IRA. A Non-Deductible IRA is a special type of Individual Retirement Arrangement in which, when an IRA is opened or started, the contributions that are made into it are not deductible from the investor’s federal income taxes. Many people turn to this option when they want to contribute to their retirement, but cannot take advantage of a tax deduction in the year that they make it.
How Does Non-Deductible IRA Work?
Non-Deductible IRAs work the same as regular, deductible IRAs. The amount that you put into a Non-Deductible IRA is deferred until retirement age, when all withdrawals are taxed at your normal income tax rate. It’s important to note that IRA rules say that you cannot deduct contributions from your taxes. You are not allowed to declare contributions as a miscellaneous deduction, nor can you claim deductions on Schedule A of your tax return either. However, this is where the part of Non-Deductible IRA rules comes into play. If you did not qualify for a traditional IRA deduction, but still want to use the Non-Deductible option, it’s very simple. When you open or start a Non-Deductible IRA account, all of your contributions will be placed in this specific type of IRA until the retirement age is reached. It will grow tax-deferred, and at retirement age, the distribution will be taxed as ordinary income.
Who Is Eligible for Non-Deductible IRA?
Anyone is eligible for Non-Deductible IRA accounts, but this account is reserved only for those who do not qualify for a traditional IRA deduction. This means that any contributions you make may not be tax deductible. Non-Deductible IRAs are available for investors who have a Modified Adjusted Gross Income (MAGI) that is below a certain amount. These are also not available for people who have access to a workplace retirement account, such as a 401(k).
Rules and Requirements
Your ability to fund Non-Deductible IRA accounts is determined by your Modified Adjusted Gross Income (MAGI). This account is only available to investors who have MAGI below a certain threshold. MAGI for singles and heads of households cannot be above $76,000. For married couples filing jointly, this MAGI must be below $125,000.
In order to have Non-Deductible IRA accounts with most financial institutions you must:
- Be under the age of 70
- Not be a participant in an employer-sponsored retirement plan
- Cannot be a Non-Spouse Beneficiary of a plan
- Have a Non-Deductible Traditional IRA, Roth IRA or rollover from a Non-Deductible traditional IRA within the last 12 months
- Be eligible to contribute to a Non-Deductible IRA based on your MAGI
If you have any of the following, you are not eligible for Non-Deductible IRA accounts:
- You are covered by another retirement plan at work, such as a 401(k), 403(b) or 457
- You will be claimed as someone else’s dependent on their income taxes this year
- Your MAGI is above $76,000 as a single person or $125,000 for those filing as married
The Non-Deductible IRA contribution limit is the same as the Traditional IRA account. However, Non-Deductible IRA contributions are not tax deductible, unlike Traditional IRA accounts. For 2021, the Non-Deductible IRA account is capped at the annual contribution limit of $6,000 if you’re younger than 50. If you’re over 50, a Non-Deductible IRA is capped at $7,000. This means Non-Deductible IRA accounts are typically better for younger investors, while older investors may benefit more from a Traditional IRA.
After Non-Deductible IRA accounts are open, you can withdraw funds at any time without paying taxes. Non-Deductible IRA withdrawals are subject to a 10% penalty if you take the money out within the first two years of starting your account. If you wait two full calendar years, though, account holders will no longer have any fees or penalties for taking distributions from their accounts.
Tax Reporting When Making Non-Deductible IRA Contributions
When making after-tax contributions to Non-Deductible IRA accounts, you will need to honestly report the income sources when filing your taxes. If you are not making contributions under the MAGI limits with funds that are already taxed, then you do not need to worry about anything else. However, if your contributions are being made with Non-Deductible funds, then you will need to report that. To report, you must inform the IRS of your contributions by filling out Form 8606, which must be attached to your tax return. Supposing that you do not report the funds coming from Non-Taxed sources, you may incur a Non-Compliant Tax. This is an additional tax that must be paid if contributions were made without full disclosure. Failure to report income sources may lose your Non-Deductible IRA treatment and you will be forced to pay taxes on all your profits.
Pros and Cons
The following are some of the pros and cons of Non-Deductible IRA accounts.
Non-Deductible IRA accounts can be useful for investors who want to put away money for retirement and don’t qualify for a deductible IRA. This is also more flexible since the account allows investors to withdraw their contributions without penalty at any time after it is opened. In addition, the account can also be helpful for those who earn a lot in the future and anticipate being in a higher tax bracket when they retire.
Non-Deductible IRAs require extensive record keeping. This account requires investors to keep track of the contributions and withdrawals, which can be complicated. This is also not the best option for those who want to save money to reduce their taxable income in retirement. The account also requires the money to be taxed as ordinary income at retirement age. In addition, Non-Deductible IRA accounts cannot be used as working income. This means the money must be saved up for retirement, which can take years to accomplish.
Those who are looking to save money for retirement that does not qualify for deductible IRA accounts may want to consider Non-Deductible IRA accounts. This type of account allows investors to take any withdrawals they have made at will, which is good for those looking to take out funds without being penalized. It can be appealing for investors who want to invest in Non-Deductible funds, but it does require extensive record keeping. If you’re unsure about Non-Deductible IRA accounts, consider talking with a financial advisor to help determine which investment option is best before making any moves.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.