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Sunday, June 23, 2024

What is a non-deductible IRA?

What is a non-deductible IRA?

02.03.2022

An IRA is one of the most popular tools available to help individuals save for retirement. But depending on your annual income, you may not be eligible for some of the tax advantages of a traditional or Roth IRA. That’s where a non-deductible IRA comes in.

A non-deductible IRA isn’t actually a type of retirement account. Instead, it refers to non-deductible contributions that you make to a traditional retirement account. It’s a type of retirement savings strategy available to those whose income exceeds the limits to make deductible IRA contributions or to contribute to a Roth IRA.

Wondering whether a non-deductible IRA is right for you? Keep reading to learn how a non-deductible IRA works, who they are for, and what you need to know about using one.

How a non-deductible IRA works

An IRA is a tax-advantaged account that allows you to either deduct your contributions (traditional) or withdraw money tax-free during retirement (Roth). But there are some restrictions around who can enjoy the tax benefits of most IRAs.

The term “non-deductible IRA” refers to traditional IRA contributions you make that aren’t eligible for the tax advantages of a traditional IRA. Even if you don’t qualify for deductible IRA contributions, you can still make contributions to the account. Any growth in your account will still be tax deferred, meaning the account still provides some shelter from taxes throughout your working years. Then, once you begin taking distributions during retirement, you’ll pay income taxes on the growth of that money.

How a non-deductible IRA differs from other retirement accounts

The primary difference between a non-deductible IRA and other types of IRAs is that you don’t get some of the tax advantages. To clarify, let’s discuss the tax advantages of the two most popular types of IRAs — traditional and Roth — compared to those of a non-deductible IRA.

Traditional IRA

When you contribute to a traditional IRA, you’re able to claim a tax deduction for your contributions. As a result, you can reduce your taxable income for tax-year 2023 by up to $6,500, or potentially up to $7,500 if you are 50 or older and eligible for the catch-up contribution of $1,000. Then, the money in the account grows tax deferred until you pay income taxes on it when you take distributions.

Roth IRA

In the case of a Roth IRA, the tax advantage comes at a different time from the traditional IRA. When you contribute to a Roth IRA, you can’t claim a tax deduction. Instead, any growth of the money in the account is tax-free with a qualified withdrawal, and you can withdraw it tax-free during retirement. Earnings on Roth contributions will be taxed if withdrawals are not qualified distributions as defined by the IRS.

Non-deductible IRA

When you contribute to a non-deductible IRA, you can’t claim a tax deduction. The only real tax advantage is that any growth of your money is tax-deferred in the account. As a result, you won’t have to worry about paying taxes on your money while it potentially grows.

IRA eligibility

If you are making non-deductible IRA contributions, it likely means you don’t meet the eligibility requirements of either a traditional or Roth IRA.

Whether or not you can make deductible contributions to a traditional IRA depends on a few factors. You must:

  • Fall below the threshold for modified adjusted gross income (MAGI)
  • Have earned income (wages or self-employment income)

If you are covered by a workplace retirement plan, you must fall within the income limits below to make deductible traditional IRA contributions in the 2023 tax year:1

Filing status

Modified adjusted gross income (MAGI)

Deduction

Single or

head of household

$73,000 or less

Full deduction

$73,000 – $83,000

Partial deduction

$83,000 or more

No deduction

Married filing jointly or qualifying widow(er)

$116,000 or less

Full deduction

$116,000 – $136,000

Partial deduction

$136,000 or more

 No deduction

Married filing separately

less than $10,000

Partial deduction

$10,000 or more

 No deduction

If you aren’t covered by a workplace retirement plan, you may be able to deduct your entire traditional IRA contribution, regardless of your income. But your deductible amount also depends on whether you have a spouse who is covered by a retirement plan at work. If you aren’t covered by a workplace retirement plan, you must fall within the income limits below to make deductible traditional IRA contributions in 2023:2

Filing status

Modified adjusted gross income (MAGI)

Deduction

Single, head of household, or qualifying widow(er)

Any amount

Full deduction

Married filing jointly or separately with a spouse who is not covered by a plan at work

 Any amount

Full deduction

Married filing jointly with a spouse who is covered by a plan at work

$218,000 or less

Full deduction

$218,000 – $228,000

Partial deduction

$228,000 or more

No deduction

Married filing separately with a spouse who is covered by a plan at work

less than $10,000

Partial deduction

$10,000 or more

No deduction

Anyone can contribute to a traditional IRA, even if they don’t meet the requirements to take a tax deduction for their contributions. But the same can’t be said about a Roth IRA. You’ll have to meet the IRS requirements for this type of retirement account to even contribute.

If you’re single, head of household, or married and filing separately with a spouse you don’t live with, then you may contribute up to the contribution limit to a Roth IRA if you earn less than or equal to $138,000.3 If your income exceeds $138,000, you can only contribute a reduced amount. But once your income reaches $153,000, you can’t contribute at all.4

For married folks filing jointly, the income cap is $218,000 to contribute the full amount. Allowed contributions are reduced until they phase out entirely when your joint income exceeds $228,000.5

Non-deductible IRA rules

As with other retirement accounts, there are a handful of rules you’ll have to follow to ensure you’re using the non-deductible IRA correctly. The key things to know include the filing requirements, contribution limits, and distribution rules.

Filing requirements 

The IRS requires that anyone who makes non-deductible IRA contributions files Form 8606 with their annual tax return each year. The purpose of this form is to document your after-tax contribution. If you fail to complete it, then you may be subject to additional taxes later on.

Contribution limits

The IRS limits the amount that someone can contribute to an IRA each year. In 2023, the limit for both deductible and non-deductible IRA contributions is $6,500 ($7,500 for those age 50 or older).

It’s important to note that to contribute to an IRA you must have earned income, and your IRA contributions can’t exceed your earned income for the year. Since non-deductible IRA contributions are primarily used by those whose income is too high to allow them to take advantage of deductible or Roth IRA contributions, this likely won’t be a concern.

Distribution rules

When you take distributions from your non-deductible IRA, you’ll have to pay taxes on your earnings. But because you’ve already paid taxes on your contributions, you won’t be taxed again for them.

Unfortunately, when you withdraw money from your non-deductible IRA, you can’t choose whether to take taxable or non-taxable distributions. Instead, each distribution will be split proportional to the percentage of contributions versus earnings in the account. So if your account is 75% non-deductible contributions and 25% taxable earnings, then 25% of your distribution will be taxable.

You can begin taking penalty-free distributions from your non-deductible IRA at age 59½. If you withdraw funds earlier, you’ll pay a 10% penalty on your distribution unless you qualify for an exception. The IRS also requires that you begin taking required minimum distributions (RMDs) once you reach age 72 (70½ if you reached 70½ before January 1, 2020). RMDs don’t apply to Roth IRAs, but they do apply to both deductible and non-deductible IRA contributions.

What to consider before using a non-deductible IRA

One of the greatest advantages of contributing to IRAs is that you can either reduce your taxable income in the year that you make a contribution or reduce your tax burden during retirement. Unfortunately, a non-deductible IRA doesn’t come with those same advantages. As a result, it’s not as powerful a tool for reducing your tax burden while saving for retirement.

That being said, let’s not write off the non-deductible IRA altogether. There are still some advantages worth talking about.

First, a non-deductible IRA still provides a way to set aside money for retirement and invest it for growth. And considering that a quarter of US adults6 have no retirement savings, we can agree that saving for retirement at all is an important step.

It’s also important to remember that just because the non-deductible IRA doesn’t have as many tax advantages as deductible or Roth IRAs doesn’t mean there aren’t any advantages. As we’ve discussed, any growth of the money in a non-deductible IRA is tax deferred. As a result, you’re still reducing your tax burden during your working years. After all, if those investments were in a taxable brokerage account, you might be subject to taxes on your capital gains, interest income, dividends, etc.

Finally, there are other steps you can take to ensure that non-deductible IRA contributions are made after you have fully taken advantage of any tax breaks available to you. Here are a few steps you can take before you make non-deductible IRA contributions:

Learn your IRA contribution eligibility: In most cases, someone makes non-deductible IRA contributions because they aren’t eligible to make deductible or Roth contributions. But even if you don’t think you’re eligible or haven’t been eligible in the past, it’s worth double-checking just to make sure you aren’t leaving tax breaks on the table.

Max out your workplace retirement account: If your workplace offers a retirement plan like a 401(k) plan, focus your contributions there before turning to a non-deductible IRA. Contributions to a 401(k) are deductible no matter your income. If you’re already maxing out your contributions, you can choose to contribute to both a 401(k) and an IRA.

Consider a self-employed retirement plan: If you’re self-employed, consider one of the many retirement savings vehicles available to you there, including a SEP IRA, SIMPLE IRA, or Solo 401(k). Contributions to those accounts are tax-deductible.

Non-deductible IRAs and backdoor Roth conversions

If you have already contributed to a non-deductible IRA or plan to do so in the future, there’s one key tool you can use to gain some serious tax advantages. That tool, known as the backdoor Roth IRA, allows you to convert the money in your traditional retirement account into a Roth IRA.

Unlike normal Roth IRA contributions, which are only available to those who fall under a certain income, a Roth conversion is available to anyone, regardless of their tax bracket. And once the money is in a Roth IRA, it will grow tax-free — and you won’t pay taxes on it during retirement.

The advantage of a non-deductible IRA-to-Roth IRA conversion is that you aren’t subject to the biggest downside of most Roth IRA conversions: the taxes. When someone converts deductible contributions from a traditional IRA to a Roth IRA, they must pay income taxes on that money. For someone with a large IRA balance, the taxes could be significant. But because you’ve already paid taxes on your non-deductible IRA contributions, there’s no tax burden to converting that money to a Roth IRA.

Remember, though, that you can’t choose whether to take out deductible or non-deductible contributions; you have to take them out in proportion to one another. This means that if your non-deductible IRA has both deductible and non-deductible contributions, converting to a Roth IRA may come with a tax burden. We recommend talking to your financial professional about the details before taking action.

The bottom line

Many people love IRAs for the tax advantages they offer, such as allowing them to reduce their tax burden either in the years they make contributions or during retirement. Unfortunately, IRS income limits prevent certain taxpayers from enjoying the full tax benefits of a deductible traditional IRA or a Roth IRA.

While the non-deductible IRA may not be as powerful as its traditional and Roth alternatives, it still provides a way to enjoy some tax advantages while boosting your retirement nest egg. And you may even be able to use a Roth conversion to convert your non-deductible IRA contributions into a tax-advantaged account to enjoy tax-free distributions during retirement.

Remember that non-deductible IRA contributions require additional tax forms, and a Roth conversion can be a bit complex. If you’re using this type of account, you may want to enlist the help of a financial or tax expert to help.

1 IRS.gov, “2023 IRA Deduction Limits,” October 2022.

2 IRS.gov, “2023 IRA Deduction Limits – Effect of Modified AGI on Deduction If You Are NOT Covered by a  Retirement Plan at Work,” October 2022.

3 IRS.gov, “Amount of Roth IRA Contributions That You Can Make For 2023,” October 2022.

4 IRS.gov, “Amount of Roth IRA Contributions That You Can Make For 2023,” October 2022.

5 IRS.gov, “Amount of Roth IRA Contributions That You Can Make For 2023,” October 2022.

6 PricewaterhouseCoopers, “Retirement in America,” 2022.

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