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What Is a Non-Deductible IRA?

By Laurel Tincher · June 01, 2022 · 6 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is a Non-Deductible IRA?

A non-deductible IRA is what it sounds like: An IRA, or IRA contributions, that cannot be deducted from your income. So whereas contributions to a traditional IRA are tax-deductible, non-deductible IRA contributions offer no immediate tax break.

In both cases, though, contributions grow tax free over time — and in the case of a non-deductible IRA, you wouldn’t owe taxes on the withdrawals in retirement.

Why would you open a non-deductible IRA? If you meet certain criteria, e.g. your income is too high to allow you to contribute to a traditional IRA, or even a Roth IRA, a non-deductible IRA might help you increase your retirement savings — or convert to what’s known as a backdoor Roth IRA.

It helps to understand how non-deductible contributions work, what the rules and restrictions are, as well as the potential benefits and risks.

Who Is Eligible for a Non-Deductible IRA?

Several factors determine whether an individual is ineligible for a traditional IRA, and therefore their contributions could fund a non-deductible IRA. These include an individual’s income level, tax-filing status, and access to employer-sponsored retirement plans like a 401(k) (even if the individual or their spouse don’t participate in such a plan).

If you and your spouse do not have an employer plan at work, there are no restrictions on fully funding a regular, a.k.a. deductible, IRA. You can contribute up to $6,000 in 2022; $7,000 if you’re 50 and older. And those contributions are tax deductible.

However, if you’re eligible to participate in an employer-sponsored plan, or if your spouse is, then the amount you can contribute in 2022 to a deductible IRA phases out — e.g. the amount you can deduct gets smaller — based on your income:

•   For single filers/head of household: from $68,000 to $78,000. Above $78,000 you can only contribute to a non-deductible IRA.

•   For married, filing jointly:

◦   If you have access to a workplace plan, the phaseout is from $109,000 to $129,000

◦   If your spouse has access to a workplace plan, the phaseout is from $204,000 to $214,000.

Non-Deductible IRA Withdrawal Rules

Now for the important part: Taxes. The other big difference between an ordinary, deductible IRA and a non-deductible IRA is how withdrawals are taxed after age 59 ½. (Remember that IRA withdrawals prior to that may be subject to an early withdrawal penalty.)

•   Regular (deductible) IRA: Contributions are made pre-tax. Withdrawals after 59 ½ are taxed at the individual’s ordinary income rate.

•   Non-deductible IRA: Contributions are after tax (i.e. you’ve already paid tax on the money). Withdrawals are therefore not taxed, because the IRS can’t tax you twice.

To make sure of this, you must report non-deductible IRA contributions on your tax return, but you use Form 8606 to do so. Form 8606 officially documents that some or all of the money in your IRA has already been taxed and is therefore non-deductible. Later on, when you take distributions, a portion of those withdrawals will not be subject to income tax.

If you have one single non-deductible IRA, then the treatment is similar to a Roth IRA. You deposit money you’ve paid taxes on, and your withdrawals are tax free.

It gets more complicated when you mix both types of contributions — deductible and non-deductible — in a single IRA account. Here’s an example of different IRA withdrawal rules:

Let’s say you qualified to make deductible IRA contributions for 10 years, and now you have $50,000 in a regular IRA account. Then, your situation changed, perhaps your income increased, and now only 50% of the money you deposit is deductible; the other half is non-deductible.

You contribute another $50,000 in the next 10 years, but only $25,000 is deductible; $25,000 is non-deductible. You diligently record the different types of contributions using Form 8606, so the IRS knows what’s what.

When you’re ready to retire, the total balance in the IRA is $100,000, but only $25,000 of that was non-deductible (meaning, you already paid tax on it). So when you withdraw money in retirement, you’ll owe taxes on three-quarters of that money, but you won’t owe taxes on one quarter.

Contribution Limits and RMDs

There are limits on the amount that you can contribute to an IRA each year, and deductible and non-deductible account contributions have the same contribution caps. People under 50 years old can contribute up to $6,000, and those over 50 can contribute $7,000 per year.

IRA account owners are required to start taking required minimum distributions (RMDs), similar to a 401(k), from their account once they turn 72 years old. Prior to that, account holders can take money out of their account between ages 59 ½ and 72 without any early withdrawal penalty.

Individuals can continue to contribute to their IRA at any age as long as they still meet the requirements.

Benefits and Risks of Non-Deductible IRA

While there are benefits to putting money into a non-deductible IRA, there are some risks that individuals should be aware of as well.

Benefits

There are several reasons you might choose to open a non-deductible IRA. In some cases, you can’t make tax-deductible contributions to a traditional IRA, so you need another retirement savings account option. Though your contributions aren’t deductible in the tax year you make them, funds in the IRA that earn dividends or capital gains are not taxed, because the government doesn’t tax retirement savings twice.

Another reason people use non-deductible IRAs is as a stepping stone to a Roth IRA. Roth IRAs also have income limits, but they come with additional choices. High income earners can start by contributing funds to a non-deductible IRA, then convert that IRA into a Roth IRA. This is called a backdoor Roth.

One thing to keep in mind with a backdoor Roth is that the conversion may not be entirely tax free. If an IRA account is made up of a combination of deductible and non-deductible contributions, when it gets converted into a Roth account some of those funds would be taxable.

Risks

The primary benefits of non-deductible IRAs come when used to later convert into a Roth IRA. It can be risky to keep a non-deductible IRA ongoing, especially if it’s made up of both deductible and non-deductible contributions, which can be tricky to keep track of for tax purposes. You can keep a blended IRA, it just takes more work to keep track of the amounts that are taxable.

As noted above, it requires dividing non-deductible contributions by the total contributions made to all IRAs one has in order to figure out the amount of after-tax contributions that have been made.

Non-Deductible IRA vs Roth IRA

With a non-deductible IRA, you contribute funds after you’ve paid taxes on that money, and therefore you’re not able to deduct the contributions from your income tax. The contributions that you make to the non-deductible IRA earn non-taxable interest while they are in the account. The money isn’t taxed when it is withdrawn later.

Roth contributions are similarly made with after-tax money and one can’t get a tax deduction on them. Also, a Roth IRA allows an individual to take out tax-free distributions during retirement.

Unlike other types of retirement accounts, a Roth IRA doesn’t require the account holder to take out a minimum distribution amount.

There are income limits on Roth IRAs, so some high-income earners may not be able to open this type of account. The non-deductible IRA is one way to get around this rule, because one can start out with a non-deductible IRA and convert it into a Roth IRA.

How Can I Tell If a Non-Deductible IRA Is the Right Choice?

Non-deductible IRAs can be a great way for high-income savers to make their way into a backdoor Roth account. This strategy can help them reduce the amount of taxes they owe on their savings. However, they may not be the best type of account for long-term savings or lower-income savers.

The Takeaway

For many people, contributing to an ordinary IRA is a clearcut proposition: You deposit pre-tax money, and the amount can be deducted from your income for that year. Things get more complicated, however, for higher earners who also have access (or their spouse has access) to an employer-sponsored plan like a 401(k) or 403(b). In that case, you may no longer qualify to deduct all your IRA contributions; some or all of that money may become non-deductible. That means, you deposit funds post tax and you can’t deduct it from your income tax that year.

In either case, though, all the money in the IRA would grow tax free. And the upside, of course, is that with a non-deductible IRA the withdrawals are also tax free. With a regular IRA, because you haven’t paid taxes on your contributions, you owe tax when you withdraw money in retirement.

If you’re ready to open your own IRA, you’ve come to the right place. You can open an Active Invest account with SoFi Invest in minutes. The online trading platform lets you research, track, buy and sell stocks, ETFs, crypto, and other assets right from your laptop or phone. If you need help getting started, SoFi has a team of professional financial advisors available to answer your questions and help you create a personalized investing plan to reach your goals.

Get started investing for your future today.


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Photo credit: iStock/Drazen Zigic
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