Any Nondeductible Contributions to Your IRA? Here’s What to Know

Individual Retirement Accounts (IRAs) are a popular choice for individuals looking to secure their financial future. However, not all contributions to an IRA qualify for tax deductions, leading to the concept of nondeductible contributions. Understanding these is key for effective retirement planning and compliance with tax regulations.

Determining Eligibility for Tax Deductions

Eligibility for tax deductions on IRA contributions depends on current tax laws and income thresholds. The IRS sets guidelines based on your modified adjusted gross income (MAGI) and whether you participate in an employer-sponsored retirement plan. For example, in 2024, single individuals covered by a workplace plan face a deduction phase-out between a MAGI of $73,000 and $83,000. Married couples filing jointly have a phase-out range of $116,000 to $136,000 if the contributing spouse is covered by a workplace plan.

Exceeding these thresholds makes contributions nondeductible. While such contributions won’t reduce taxable income, they can still grow tax-deferred. This shift impacts both current and future tax scenarios.

Calculating the Nondeductible Portion

If your contributions are nondeductible, calculating the nondeductible portion is essential to avoid overpaying taxes when withdrawing funds. The IRS requires tracking your basis in the IRA, which is the total of all nondeductible contributions made over time. This basis determines the tax-free amount of your distributions.

To calculate the nondeductible portion, determine your total year-end IRA balance, including contributions and earnings. Then calculate the proportion of your total IRA balance attributable to nondeductible contributions. For instance, if your IRA balance is $100,000 and your basis is $20,000, 20% of any withdrawal is tax-free. This percentage must be updated annually as your IRA balance and contributions change.

Form 8606 must be used to track nondeductible contributions and the basis. Accurate records are critical to avoid double taxation on the same funds.

Reporting Your Contributions

Accurate reporting of nondeductible IRA contributions is crucial for compliance and minimizing future tax liabilities.

Form 8606

IRS Form 8606, “Nondeductible IRAs,” is used to report nondeductible contributions and track your basis. Failure to file the form can result in a $50 penalty. The form requires details such as the year’s nondeductible contributions and the cumulative basis. For example, a $5,000 nondeductible contribution in 2023 should be reported on Form 8606 to update your basis.

Record Retention

Maintaining records of nondeductible contributions is essential for tax compliance and planning. Retain copies of tax returns, Form 8606 filings, and IRA custodian statements for as long as the account is open and distributions are made. Proper documentation is key in case of an audit or discrepancies in your reported basis.

Allocating Contributions

Allocating contributions between deductible and nondeductible amounts requires precision, especially with multiple IRAs or contributions to both traditional and Roth IRAs. The IRS treats all traditional IRAs as one account for tax purposes. When calculating the tax-free portion of a distribution, you must consider the total basis across all traditional IRAs. For example, if your combined basis is $30,000 and your total IRA balance is $150,000, 20% of any distribution is tax-free.

Potential Penalties for Incorrect Filing

Inaccuracies in filing nondeductible IRA contributions can result in penalties or additional taxes. Failing to file Form 8606 or filing it incorrectly may lead to a $50 penalty. Errors in reporting can also understate your basis, causing more of your distributions to be taxed than necessary. Persistent inaccuracies could trigger an IRS audit.

Coordination With Required Distributions

Understanding how nondeductible contributions interact with required minimum distributions (RMDs) is important for long-term tax planning. At age 73 (or 72 if you turned 72 before January 1, 2023), the IRS requires RMDs from traditional IRAs. For accounts with nondeductible contributions, only earnings and deductible contributions are taxable, while the nondeductible portion remains tax-free.

To calculate the tax-free portion of each RMD, determine the proportion of nondeductible contributions to your total IRA balance. For example, if your total IRA balance is $500,000, and your nondeductible basis is $50,000, 10% of your RMD will be tax-free. This calculation must account for all traditional IRAs combined, as the IRS treats them as a single entity. Errors in allocation can lead to overpayment of taxes or penalties for underreporting taxable income.

RMDs also impact overall financial strategy by increasing taxable income, potentially pushing you into a higher tax bracket or affecting eligibility for tax credits or benefits like Medicare premiums. Properly accounting for nondeductible contributions can reduce taxable income from RMDs. Strategic planning, such as timing withdrawals or converting portions of your IRA to a Roth IRA before RMDs begin, can further optimize tax outcomes. Integrating nondeductible contributions into a broader retirement strategy is essential for maximizing financial efficiency.