If you are not eligible to take an IRA deduction for your contribution to an IRA, and you make too much money to make a ROTH IRA contribution, then you might consider making a non-deductible IRA contribution.
Non-Deductible IRA Basics
- A non-deductible IRA has the same contribution limits and is subject to the same rules as a Traditional IRA – the difference is how the contribution is treated on your tax return.
- You can make non deductible IRA contributions to the same IRA account that has deductible contributions, however, for tracking purposes I would advise you open a separate account for all non-deductible contributions.
- With your tax return you will need to file a form 8606 where you report the amount of your IRA contribution that was non-deductible. This is called your basis.
- One of the most effective uses of non-deductible IRAs is for high income earners. High income earners can use non-deductible IRAs to contribute to a ROTH IRA.
Using a Non-Deductible IRA Contribution to Contribute to a ROTH
For those who earn enough money that they are not eligible to make a ROTH IRA contribution, they can still contribute money to a ROTH IRA in a round-a-bout way. Each year you can make a non-deductible IRA contribution and then convert that non-deductible IRA to a ROTH.
When you convert an IRA to a ROTH IRA you pay taxes on any amount that is converted that is above your basis. If you have other IRA accounts your basis must be calculated using a pro-rata formula. For example, supposed you have $10,000 in a traditional IRA, and you made a $5,000 contribution to a separate IRA account as a non-deductible IRA. It would be nice if you could convert just the non-deductible IRA, however, the IRS would look at all your IRA accounts combined, and so if you converted the $5,000, one-third of it would be considered basis and the other two-thirds would be considered taxable income. This tax calculation is covered in length in the tax cost of converting a ROTH.
Non-Deductible IRA Mistakes
The most common mistake made with non-deductible IRAs is forgetting to complete IRS form 8606 with your tax return. If you have made non-deductible IRA contributions but did not report your basis, you can report it in arrears. See I forget to file form 8606 for details on what to do.
Another common mistake is thinking you can convert only your non-deductible IRA contributions to a ROTH. As discussed above, you have to look at the total of all your IRA accounts when determining the amount of tax owed when you convert to a ROTH. You can get around this by rolling traditional IRA balances into an employer plan, like a 401k plan, leaving only your non-deductible IRA balances outside of the plan. The IRS asks for year-end account balances so you would need to roll traditional IRAs into a 401k plan before year end. Then the following year convert non-deductible IRAs to a ROTH. Learn more in The Backdoor ROTH IRA.