If your income exceeds specific levels, you may not be able to make tax-deductible contributions to your traditional IRA, or the amount of your contribution may be limited. Certain restrictions may affect your ability to deduct your contributions.1
But you still can save for your retirement with a nondeductible IRA contribution. Although your nondeductible IRA contributions won’t reduce your taxes in the year you make them, you can defer taxes on the earnings your contributions make, just as you can with the rest of your contributions to your traditional IRA.
Nondeductible IRA Contributions Build for the Future
Although you don’t receive any immediate tax benefit from a nondeductible IRA contribution, the growth can be significant, and it may ultimately make the contribution worthwhile, especially if you expect to have a lower tax rate after you retire than you do now. In other words, if you expect your income (and your tax rate) to continue rising, you may want to pay taxes on earnings as you go, rather than defer them.
When you take your standard IRA distributions during retirement, you pay taxes on the growth. But any nondeductible IRA contributions are treated as your basis (your sum total). Since you effectively paid tax on the money when you made the contribution, you won’t have to pay tax on it again later. The IRS keeps track of filers who have paid taxes on nondeductible contributions with the mandatory Form 8606.2
Let’s say you made a $2,000 nondeductible contribution one year ago, and your account balance, through additional deductible contributions and investment growth, was worth $20,000 when you make a withdrawal. If you were to make a $1,000 withdrawal during retirement, only $900 would be considered taxable income, since 10% ($2,000 divided by $20,000) was a return of a nondeductible basis.
Contribution Limits for IRAs
Rules for IRA contributions are complex, and it pays to review them each year. Also, the contribution limits can vary from year to year. For tax years 2019 and 2020:
- If you’re 50 and older, you can put a combined total of $7,000 into your Traditional and Roth IRAs.
- If you’re 49 and younger, you can put a combined total of $6,000 into your Traditional and Roth IRAs3 .
These limits don’t apply to rollover contributions or qualified reservist repayments.
If you contribute more than the annual limit to your IRA, the IRS will levy a 6% tax per year on the excess amount until you remove those contributions.3
Income Restrictions for IRAs
However, you may not be able to deduct everything you contribute to a traditional IRA. If you’re employed by a company that offers a workplace retirement account such as a 401(k) or 403(b), you face certain income limits for deducting your IRA contributions. This is true regardless of whether you choose to participate in the workplace retirement plan.1
For tax year 2019, if you’re covered by a retirement plan at work, the following rules apply:
- Single or head of household and your adjusted gross income (AGI) is $64,000 or less—you’re eligible to take the full deduction
- Married filing jointly or as a qualified widow(er), AGI $103,000 or less—take the full deduction4
- Married filing jointly and your spouse is covered by a workplace plan, but you’re not—you can deduct the full amount if you make $193,000 or less5
- Married filing separately, AGI less than $10,000—claim a partial deduction
For tax year 2020, the AGI limits increase slightly for those covered by an employer-sponsored retirement plan:
- Single or head of household, AGI $65,000 or less—you can claim the full deduction
- Married filing jointly or a qualifying widower, AGI $140,000 or less—you can claim the full deduction
- Married filing separately, AGI less than $10,00—claim a partial deduction6
- Married filing jointly and your spouse is covered by a retirement plan through work, but you’re not—take the full deduction if your AGI is $196,000 or less7
Deductions are phased out from there as income rises. If you’re married filing separately, you’re subject to more stringent income rules, although if you’re separated and have lived apart for the entire year, you’re treated as a single payer by the IRS for these limits.
If neither you nor your spouse is eligible to participate in a workplace retirement plan, you may make deductible IRA contributions as long as you (or your spouse) have any earned income, regardless of how much you make.
Roth IRA as an Alternative
If you are eligible for an employer-sponsored 401(k) and have income exceeding the limits for a regular IRA deduction, you may still be eligible for a Roth IRA contribution, which has significantly higher income limits.8 If this is your situation, it typically makes sense to choose a Roth IRA contribution over a nondeductible IRA. After all, while neither contribution is deductible, with a regular IRA, the contribution grows tax-deferred, but a Roth IRA contribution grows tax-free.
The Bottom Line
Choosing the best strategy for your retirement accounts is an ongoing process, and the best decisions depend on your age, income, and retirement goals. Consult a financial advisor to help you decide the best way to maximize tax savings in your situation, whether through nondeductible IRA contributions or otherwise.