There are two main types of IRAs: Traditional and Roth.
- Traditional IRAs are funded with pre-tax income, and you receive a tax deduction on your contributions. Withdrawals in retirement are taxed as regular income.
- Roth IRAs are funded with post-tax income, meaning you don’t get any tax deductions on contributions. However, withdrawals in retirement are tax-free.
What is a non-deductible IRA?
A non-deductible IRA is a special type of traditional IRA where contributions are actually made with post-tax dollars. You don’t get any tax deductions on your contributions, and withdrawals of your earnings in retirement are also taxed as regular income. However, you do get tax-free growth on your investments and don’t have to pay any taxes on your gains until you start taking distributions in retirement. The difference between a non-deductible and a traditional IRA is that you only pay partial taxes on your withdrawals: Instead of paying taxes on the entire withdrawn amount (like a traditional IRA), you only pay taxes on your earnings. The contributions portion of your account can be withdrawn tax-free since you contributed with post-tax income.
Why would anyone choose to contribute to a non-deductible IRA over a regular traditional or Roth IRA? It turns out, there are many benefits to a non-deductible IRA that may not be apparent at first glance.
Also read: The 8 Different Types of IRAs Compared
Why contribute to a non-deductible IRA?
Since you have to pay taxes on your contribution, and when you withdraw in retirement, what’s the benefit of contributing to a non-deductible IRA?
A non-deductible IRA is used by individuals who exceed the income limits of a traditional or Roth IRA.
If your income is too high to contribute to a Roth IRA, and also too high to receive any tax deductions on your contributions to a traditional IRA, contributing to a non-deductible IRA can make sense. You’ll still enjoy tax-free growth on your investments held in your account, and will only pay taxes when you withdraw in retirement. Unlike a traditional IRA, only your earnings in your account will get taxed when you take withdrawals, but the contributions portion of your account can be withdrawn tax-free, since you contributed with post-tax income.
To report that you made the contribution into your non-deductible IRA as post-tax income, you must report the non-deductible contributions each year using IRS Form 8606.
A Roth IRA doesn’t let you make contributions if your modified adjusted gross income (MAGI) exceeds $153,000 for 2023. You can still contribute to a traditional IRA even with a high income, but if your income exceeds $83,000 for 2023, you’ll receive no tax deduction on your contributions.
Detailed income limits for a Roth IRA in 2023
- If your MAGI is $138,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,500 ($7,500 if age 50+).
- If your MAGI is over $138,000 but less than $153,000, your contribution limit gets reduced.
- If your MAGI is over $153,000, you cannot contribute at all.
To be able to make the full contribution into a Roth IRA for 2023, your income must be under $138,000.
Detailed income limits for a traditional IRA in 2023
- If your MAGI is $73,000 or less, you get get a tax deduction up to the maximum traditional IRA contribution limit of $6,500 ($7,500 if age 50+).
- If your MAGI is over $73,000 but less than $83,000, you’ll get a partial tax deduction.
- If your MAGI is over $83,000, you get no tax deduction.
To be able to get the full tax-deduction on your contributions for 2023, your income must be under $73,000.
How to calculate your MAGI
- Figure out your total income by adding up all the money you made from your job, side hustles, investments, and pretty much any other way you earned cash.
- Then, minus any tax deductions, like the part of your self-employment tax you can deduct, money you put into IRAs and health savings accounts, and any deductible interest on your student loans.
- Finally, add back any deductions from tax-free accounts and interest income that’s tax-exempt.
Rules and characteristics of a non-deductible IRA
Contributions are made with post-tax income
Unlike a regular traditional IRA, your contributions are made with income that you’ve already paid taxes on. You won’t get any tax deductions for your contributions.
Withdrawals are partially taxed
With a traditional IRA, your entire withdrawal amount in retirement gets taxed as regular income, since you didn’t pay any taxes on your contribution. With a Roth IRA, your withdrawals are completely tax-free since you already paid taxes on your contribution. When you withdraw from a non-deductible IRA, the earnings portion of your account is taxed as regular income, but the contributions portion of your account can be withdrawn tax-free, since you already paid taxes on that amount when you contributed.
Investments are tax-deferred
Like other retirement accounts, a non-deductible IRA gives you tax-free compounding on your investments. This means that interest, dividends, and capital gains are not subject to taxes until they are withdrawn from the account.
No income limits
A Roth IRA prevent high income earners from making contributions and a traditional IRA prevent high income earners from receiving a tax-deduction on their contribution. A non-deductible IRA has no income limits.
What is the contribution limit of a non-deductible IRA?
The contribution limit of a non-deductible IRA is the same as a traditional or Roth IRA. You can contribute up to $6,500 in 2023, or up to $7,500 if you’re at least 50 years of age.
The contribution of a non-deductible IRA, traditional IRA, and Roth IRA are all aggregated. Your total contributions to all accounts must not exceed the total IRA contribution limit of $6,500 ($7,500 if age 50+) for 2023.
When can you withdraw from a non-deductible IRA?
You can take qualified distributions from your non-deductible IRA once you reach the age of 59½. Withdrawals of contributions are tax-free since you funded the account with post-tax income, but withdrawals of earnings will be taxed as regular income.
If you withdraw before the age of 59½, you will receive a 10% early distribution penalty plus income taxes on the amount withdrawn.
Does a non-deductible IRA have required minimum distributions (RMD)?
Yes, like a traditional IRA, a non-deductible IRA also has required minimum distributions. You’re required to start taking distributions from your account once you reach the age of 73. You can calculate how much you’re required to withdraw using this RMD table.
A Roth IRA has no RMDs.
Traditional IRA vs Non-deductible IRA
A non-deductible IRA starts to make sense when you think about it this way:
The main benefit of a traditional IRA is that you receive a tax-deduction on your contribution. For example, if you made $30,000 income and decide to contribute $5,000 to a traditional IRA, your reportable taxable income for the year becomes $25,000 ($30,000 minus $5,000).
However, if you make above $83,000 you lose the ability to receive a tax deduction for your traditional IRA contributions. So essentially, you’re contributing with post-tax income, not getting any tax deductions, but having to pay taxes again when you take withdrawals in retirement.
Since you’re not getting any tax deductions anyways, contributing a non-deductible IRA can make more sense since withdrawals in retirement are only partially taxed.
When you withdraw money from a non-deductible IRA during retirement, only the earnings portion of the withdrawal (interest, dividends, and capital gains) will be subject to income tax. The original contribution amount, which has already been taxed, will not be subject to additional taxation upon withdrawal. So, while you don’t get an upfront tax break with a non-deductible IRA as you do with a deductible traditional IRA or a Roth IRA, you don’t pay taxes twice on your contributions either.
Converting a non-deductible IRA to a Roth IRA
Oftentimes, a non-deductible IRA is used as a vehicle to make backdoor contributions to a Roth IRA. This works similarly to a regular backdoor Roth IRA, where you contribute to a traditional IRA first, and then immediately roll over the funds into a Roth IRA.
Here’s how it works:
A Roth IRA gives you tax-free withdrawals in retirement and it has no RMDs so you can compound your money longer, as long as you’re still alive. However, the Roth IRA prevents high income earners from making contributions, and these income limits are adjusted annually by the IRS. As mentioned earlier, you cannot contribute to a Roth IRA for 2023, if your MAGI exceeds $153,000.
However, since a non-deductible IRA has no income limits, you can contribute to a non-deductible IRA first, and then immediately rollover the funds to a Roth IRA. Since the Roth IRA income limits only apply to contributions, rollovers from other retirement accounts, like a non-deductible IRA, are still allowed.
Also read: Benefits & Tax Advantages of a Roth IRA
Tax considerations for performing a rollover to a Roth IRA
If you’re only converting non-deductible IRA contributions to a Roth IRA, you won’t owe any income taxes since both accounts are funded with post-tax income. You already paid income taxes on your non-deductible IRA contributions.
However, if you also hold assets in a traditional IRA, or have accumulated any earnings in your non-deductible IRA, part of the converted funds must be included in the conversion per the IRS’ pro rata rules.
If you’re doing a backdoor conversion from a non-deductible IRA to a Roth IRA, you’ll want to speak with a financial advisor first, as you’re responsible for calculating your tax liabilities for the conversion.