Certain taxpayers will not be able to deduct IRA contributions due to hitting certain income phase out limits. However, this does not mean that they cannot contribute to an IRA. A taxpayer can always make a nondeductible contribution to an IRA when a deduction is not allowed or not allowed in full because there are no AGI limitations on making nondeductible contributions.
Nondeductible IRA Contributions and Tax Returns
Generally, for tax year 2013, if you’re married and file taxes jointly, you can’t make Roth IRA contributions if your modified adjusted gross income (MAGI) tops $188,000. If you don’t file jointly, you can’t make Roth IRA contributions when your MAGI exceeds $127,000.
Tax Forms Required for Nondeductible IRA contribution (Form 8606)
If a nondeductible contribution is made to an IRA for 2012, Form 8606 (Nondeductible IRAs) must be filed with Form 1040. If both spouses make nondeductible IRA contributions, a separate Form 8606 for each must be completed. Form 8606 is also required if any traditional IRA distributions were received in 2012 and nondeductible contributions were made in prior years to any traditional IRA. When required, Form 8606 must be filed by itself if the taxpayer does not meet the requirements for filing an income tax return. Form 8606 is filed at the time and place the taxpayer would normally file Form 1040.
IRA Distributions with Nondeductible Amounts
A taxpayer who makes nondeductible traditional IRA contributions acquires tax basis in his traditional IRAs. Later distributions from any of the taxpayer’s traditional IRAs must be allocated between nontaxable (return of basis) and taxable. When this happens, and a taxpayer is faced with making a nondeductible IRA contribution, it would probably be better to put the funds into a Roth IRA. With the availability of Roth IRAs, few taxpayers will want to make nondeductible contributions to traditional IRAs, unless that is their only permissible option.
Tracking Nondeductible IRA Contributions
It is the taxpayer’s responsibility to keep up with the amount of deductible versus non-deductible contributions in your traditional IRA. Otherwise, you and the IRS won’t know whether you owe tax on future withdrawals from the account and you could end up paying tax twice. In addition to paying tax twice, taxpayers might be subject to an unwelcome tax penalty in their retirement by making nondeductible IRA contributions while they were working.
IRA to Roth IRA Planning Tip
Taxpayers with a high income that is too high to make a Roth IRA contribution could make a nondeductible IRA contribution, then convert the traditional IRA to a Roth IRA. Individuals are now able to convert amounts in a traditional IRA to a Roth IRA, regardless of income level or filing status. This can be a very effective retirement planning tool if you think tax rates are lower now than they will be in retirement.
IRS Form 8606
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. Reporting of annual after-tax contributions to the IRS is supposed to be done on Form 8606 and should accompany the filer’s tax return in the year in which such contributions are made in your tax return, Form 8606 is used to report these situations:
When to use Form 8606
- Nondeductible contributions you made to traditional IRAs.
- Distributions from traditional, SEP, or SIMPLE IRAs, if you have ever made nondeductible contributions to traditional IRAs.
- Conversions from traditional, SEP, or SIMPLE IRAs to Roth IRAs.
- Distributions from Roth IRAs.
Failing to record a nondeductible contribution
Failing to record a nondeductible contribution on form 8606 had no effect on the taxes you paid when you omitted the form. Where it hurts you is when distributions come out of your IRAs or you convert to a Roth IRA. Nondeductible contributions are not taxed in the future because they represent already taxed income. Because you omitted nondeductible contributions, the IRS thinks your “basis” is lower than it is and will expect more income to be taxable upon the distribution or conversion.