Understanding Non-Deductible IRAs and Their Distinctions from Roth or Traditional IRAs

 Is it logical to finance an individual retirement account (IRA) when it doesn’t offer a tax deduction? Many individuals who aren’t eligible to fully finance a deductible IRA or Roth IRA miss out on this straightforward opportunity to set aside additional retirement funds that can mature without tax implications. Unlike a 401(k) or similar salary reduction plan, you can contribute to a non-deductible IRA until the tax filing deadline.

Understanding Non-deductible IRAs 

During a tax year, if you or your spouse have enough earned income or self-employment earnings, you can add funds to an IRA. Various types of IRAs exist, including:

  1. Traditional IRA
  2. Roth IRA
  3. Non-deductible IRA

Diverging from the traditional IRA that allows tax-deductible contributions, a non-deductible IRA accepts post-tax funds. This means there’s no immediate tax advantage akin to a Roth IRA. Contrary to the previous rule that disallowed IRA contributions after reaching 70½ years, you can continue contributing at any age, provided you meet IRS criteria.

For 2024, the maximum IRA contribution is $6,000, with an added $1,000 catch-up contribution allowed if you are 50 or older. In 2024, this limit increases to $6,500, with the catch-up contribution remaining at $1,000.

Contributions can be allocated across different types of IRAs

To illustrate, in a single tax year, you could add funds to a tax-deductible, non-deductible, or Roth IRA, provided the combined contributions remain within the limit. Notably, deductible and non-deductible IRA contributions can coexist in the same account.

Eligibility for a Non-deductible IRA 

Your eligibility to fund different IRA types is contingent upon factors such as your income, tax filing status, and eligibility for an employer-sponsored retirement plan—even if no contributions are made to that plan within a tax year. When neither spouse has an employer-sponsored plan, there are no restrictions on fully funding a deductible IRA. However, if either spouse is eligible for such a plan, the following limits apply for 2024 and 2024:

  • For single or head-of-household filers, deductible IRA eligibility in 2024 is between $73,000 and $83,000 of modified adjusted gross income (MAGI).
  • For married filing jointly, the phaseout for deductible IRA eligibility in 2024 occurs between $116,000 and $136,000 of MAGI.
  • For single or head-of-household filers, Roth IRA eligibility 2024 exceeds $138,000 and $153,000 of MAGI.
  • The 2024 Roth IRA phaseout range for married filing jointly is $218,000 to $228,000 of MAGI.

To assess your eligibility, consult the IRA deduction worksheet provided in IRS Form 1040 instructions.

Non-deductible IRA Distributions 

During years of contributing to a non-deductible IRA, IRS Form 8606 must be included in your federal tax return. This form documents after-tax contributions, which are crucial for future distributions. While you can withdraw any amount from your IRA penalty-free between ages 59½ and 73, you aren’t obligated to do so. After turning 73, IRS rules require aggregating the values of all deductible and non-deductible IRAs, mandating distributions from traditional IRAs (excluding Roth IRAs).

For those who turned 72 before January 1, 2024, mandatory minimum distributions (RMDs) commenced at age 72, but if you reach 72 after December 31, 2024, RMDs kick in at age 73. Distributions from non-deductible IRAs encompass taxable and nontaxable portions if non-deductible contributions were made. The nontaxable portion stems from cumulative after-tax contributions, while the taxable portion derives from earnings on these contributions.

Calculating these ratios necessitates recalibration annually based on the December 31 values of all IRA accounts. If you possess multiple IRA accounts, distributions can be drawn from one or more accounts.

Pros and Cons of Non-deductible IRAs 

Opting for a non-deductible IRA offers an avenue to enhance retirement savings, particularly if income limitations impede contributions to other IRA types. Over time, even limited annual contributions can accumulate. For instance, contributing $6,500 annually for a decade from age 50 to 60, assuming a 6% return, could yield more than $150,000 by age 70. It’s worth noting that a significant amount of the distributions you receive may consist of tax-free returns of your contributions.

However, non-deductible IRAs necessitate meticulous record-keeping. The responsibility falls on you to track and report non-deductible contributions. Preserving forms like 1040, 8606, and Form 5498 from your IRA custodian is advised to substantiate contributions and distributions, preventing cost loss upon your passing and facilitating transfers to beneficiaries.

Is a Non-deductible IRA Equivalent to a Roth IRA? 

Non-deductible IRAs and Roth IRAs differ in tax treatment. In both, after-tax funds are contributed, with income taxes payable in the year of deposit. The key distinction lies in withdrawal taxation. Roth IRA withdrawals, typically post-retirement, escape additional taxes on both contributions and earnings. Conversely, non-deductible IRAs entail taxable earnings upon withdrawal, although contributions were post-tax.

Nevertheless, non-deductible IRAs benefit high-earning individuals who’ve maximized other retirement savings avenues, like a 401(k). Earnings within the account remain untaxed until withdrawal, allowing substantial growth over time.

Are RMDs Applicable to Non-deductible IRAs? 

Yes, non-deductible IRAs are subject to the same RMD rules as other IRAs. You must commence mandatory annual withdrawals at age 73. The exact amount varies by age and other factors.

Non-deductible IRA Contribution Limits 

The contribution caps for non-deductible IRAs mirror those of traditional IRAs. 2024, the maximum contribution is $6,500, with an additional $1,000 catch-up contribution if you’re 50 or older. These figures are annually updated.

If you cannot contribute to a traditional or Roth IRA due to income constraints, consider a non-deductible IRA as an alternative. Note that this type of IRA involves distinct tax treatment. Although annual contributions are limited, their cumulative effect can be substantial. For instance, a decade of $6,500 yearly contributions, starting at 50 and retiring at 60, with a 6% return, could amass over $150,000 by 70, a significant portion being tax-free return of contributions.