Does it make sense to fund an individual retirement account (IRA) if you don't get a tax break for it?
Many people who are not eligible to fully fund a deductible IRA or Roth IRA overlook this easy opportunity to sock away additional dollars for retirement where they can grow tax-free. And unlike a 401(k) or other salary deferral plan, you can make contributions to a non-deductible IRA up to the tax filing deadline.
Key Takeaways
- Though non-deductible IRAs lack some of the tax advantages of a traditional IRA or Roth IRA, they allow you to save more for retirement in spite of income limits.
- Non-deductible contributions have eligibility rules and contribution limits.
- Savers must keep track of their own contributions to non-deductible plans so that they can pay taxes on withdrawals accurately.
Understanding the Non-Deductible IRA
In a given tax year, as long as you or your spouse have enough earned or self-employment income, you can each contribute to an IRA. There are different types of IRAs:
- Traditional IRA
- Roth IRA
- Non-deductible IRA
Unlike a traditional IRA, which is tax-deductible, non-deductible IRA contributions are made with after-tax dollars. They provide no immediate tax benefit, similar to a Roth IRA. At one time, contributions to IRAs weren't allowed past the age of 70½. This is no longer the case. You can continue making contributions at any age as long as you meet the IRS criteria.
For 2023,the maximum you can contribute to an IRA is $6,500, with an additional catch-up contribution of $1,000 if you wereage 50 or over that year. For 2024, the limit increases to $7,000. The catch-up amount remains $1,000.
Contributions can be allocated across different kinds of IRAs. For example, you could make additions to a tax-deductible, non-deductible, or Roth IRA in a given tax year, as long as the combined contributions do not exceed the limit. And unlike a Roth IRA, deductible and non-deductible IRA contributions can be commingled in the same account.
If you turned 72 before January 1, 2023, you would have needed to begin taking required minimum distributions (RMDs) from your IRA during the year you turned 72 years old. However, if you reach age 72 after December 31, 2022, you don't need to start taking RMDs until you turn 73.
Eligibility for a Non-Deductible IRA
Your ability to fund different kinds of IRAs is subject to restrictions based on your income and tax filing status. It also depends on whether you are eligible to participate in an employer-sponsored retirement plan, even if no contributions have been made to that plan in a given tax year.
If you and your spouse do not have an employer plan at work, there are no restrictions on fully funding a deductible IRA. However, if either you or your spouse is eligible to participate in an employer-sponsored plan, the following limits apply in 2023 and 2024:
- For a deductible IRA, eligibility in 2023 phases out between $73,000 and $83,000 of modified adjusted gross income (MAGI) if you are filing as single or head of household. For 2024, the range increases to $77,000 to $87,000.
- For a deductible IRA, the phaseout in 2023 is between $116,000 and $136,000 of MAGI if you are married filing jointly. For 2024, the range increases to $123,000 to $143,000.
- For a Roth IRA, 2023 eligibility phases out between $138,000 and $153,000 of MAGI if you are filing as single or head of household. For 2024, the range increases to $146,000 to $161,000.
- For a Roth IRA, the 2023 phaseout is between $218,000 and $228,000 of MAGI if you are married filing jointly. For 2024, the range increases to $230,000 to $240,000.
To help determine your eligibility, there is an IRA deduction worksheet in the instructions for IRS Form 1040.
Distributions From a Non-Deductible IRA
For any year you contribute to a non-deductible IRA, you need to include IRS Form 8606 in your federal tax return. This form documents your after-tax contribution, which is important once you begin taking distributions.
Between ages 59½ and 73, you are free to take any amount out of your IRA without a penalty, but you are not required to do so. Once you reach age 73, the IRS requires you to aggregate the value of all your deductible and non-deductible IRAs and begin taking distributions from your traditional (but not Roth) IRAs.
If you turned 72 before January 1, 2023, you would have needed to begin taking required minimum distributions (RMDs) from your IRA during the year you turned 72 years old. However, if you reach age 72 after December 31, 2022, you don't need to start taking RMDs until you turn 73.
If you made non-deductible contributions, then any distribution contains both a taxable and a nontaxable portion. The nontaxable portion is based on your cumulative after-tax contributions, and the taxable portion is based on the money those contributions earned over time. For example, over the years, you contributed $50,000 to a non-deductible IRA, and by age 73, the account grew to $75,000. Roughly 33% ($25,000) of the account valuewould beappreciable and taxable.
The actual amount of your RMD is determined by an IRS table based on your age. Your IRA custodian may send you a statement of how much you need to take out, but this work is best done by a tax advisor who can also help you figure out how much of your RMD is taxable if it includes non-deductible contributions. It's also important to keep records of your contributions.
The computation to determine the taxable and nontaxable ratio needs to be recalculated every year based on the December 31 value of all your IRA accounts. For investors with more than one IRA account, the distribution can be drawn from each account or just one.
Pros and Cons of a Non-Deductible IRA
Opening a non-deductible IRA allows you to save more for retirement, even if you are restricted by your income from contributing to another kind of IRA. The more you save, and the earlier you begin saving, the better off you will be in retirement.
However, a major downside to non-deductible IRAs is record keeping. It is your responsibility to keep track of and claim any nondeductible contributions. The IRS recommends keeping your 1040 and 8606 forms, as well as the Form 5498 that you receive each year from the IRA custodian, to document your contributions and distributions.
This is important so that, upon the death of the IRA owner, the cost basis is not lost and transfers to the spouse or beneficiary.
Is a Non-Deductible IRA the Same as a Roth IRA?
A non-deductible IRA and a Roth IRA are not taxed the same. In both types of accounts, after-tax money is contributed. You pay the income tax due that year on the money that you deposit in the account.
However, a Roth IRA has a big advantage: when the money is withdrawn, usually after you retire, you won't owe additional taxes on the money you withdraw, both the contributions and the earnings.
In a non-deductible IRA, however, the earnings from your contributions will be taxable when you withdraw them.
Even so, the non-deductible IRA is a good choice for a high-wage-earner who has topped off other retirement savings options, like a 401(k). The earnings in the account will not be taxed until they is withdrawn, so there's plenty of time for the balance to grow.
Does a Non-Deductible IRA Have Required Minimum Deductions (RMDs)?
Yes. A non-deductible IRA has the same RMDs as any other IRA. You must start taking a certain amount out every year starting at age 73. How much you have to take out each year depends upon your age and other factors.
How Much Can I Contribute to a Non-Deductible IRA?
The contribution limits for a non-deductible IRA are the same as for traditional IRAs. For 2024, the maximum allowable contribution is $7,000, and the catch-up contribution is $1,000 if you are age 50 or older. These numbers are revised every year.
The Bottom Line
If you are unable to contribute to a traditional or Roth IRA because of your total income, you may still be able to contribute to a non-deductible IRA. This type of IRA has a different type of tax treatment than other IRAs.
Annual contributions to a non-deductible IRA are limited, but over time they can add up. For instance, if you contributed $6,500 a year for 10 years, beginning at age 50 and then retired at age 60, assuming a 6% rate of return, your contributions could grow to more than $150,000 by age 70. And once you start taking distributions, in this example, about 44% would be a tax-free return of your contribution.
