How are my IRA withdrawals taxed when I have nondeductible contributions?
With the tax deadline around the corner, we often get questions from our clients on whether they should be contributing to their IRA. Every bit of savings counts towards achieving your financial goals, and traditional IRAs are excellent investment vehicles given the opportunity for tax-deferred growth.
What’s important to know is that not all IRA contributions are created equal. Some investors may be able to deduct a contribution from their income, while others cannot do the same. Those contributions that are not used for a tax deduction are called nondeductible contributions. Nondeductible contributions have their own unique set of rules, and you and your accountant are responsible for adequately tracking these deposits and determining how they impact the taxation of future IRA withdrawals. Please read on to learn more about the specifics of nondeductible IRA contributions and contact Aevitas Wealth if you have any questions about how this applies to your financial plan. For our clients that are interested in contributing to an IRA before the tax deadline, please contact our office. It is always important to discuss with our team first to make sure that you are considering all savings strategies available to you.
Have you made nondeductible contributions to a Traditional IRA in the past? You may want to be conscientious in tracking over time and determining taxation upon withdrawing.
What is a nondeductible IRA contribution?
If you regularly contribute to your IRA, a portion or all of your contributions may be considered nondeductible on your tax return. Aside from a few exceptions, single filers earning over $75,000 in the 2020 tax-year receive no deduction towards income, and the phaseout begins at over $65,000 of modified AGI. Nondeductible contributions are considered after-tax dollars, while any return on investment is tax-deferred growth. Compound this tax benefit over decades, and you have an attractive opportunity for future savings towards your retirement.
How are nondeductible IRA contributions taxed when withdrawn?
It is important to understand your IRA distribution's tax treatment to ensure that you are not taxed twice on the same income. For example, Connor has an IRA with a balance of $500,000 on September 1, 2019. $100,000 consists of non-deductible (and therefore, after-tax) dollars, $200,000 is considered pre-tax since it came from an old 401(k) rollover, and $200,000 is investment earnings. He made a $20,000 withdrawal on September 1 to satisfy his Required Minimum Distribution, lowering his balance to $480,000. On December 31, 2019, his IRA balance is $490,000 since the account had a $10,000 return in the final three months of the year. What portion of his $20,000 withdrawal is considered non-taxable?
$3,921 of the distribution is considered non-taxable. For future distributions from the IRA, Connor will need to reduce his total nondeductible contributions on the Form 8606 by the non-taxable amount - $100,000 - $3,921 = $96,079 total nondeductible contributions.
What if Connor has multiple IRAs? The IRS views all of your traditional IRAs as a single IRA. That means even if you designate one of your IRAs for nondeductible contributions only, any withdrawals from that account will be taxed, assuming that both of your IRAs are combined.
Particularly for high-earners, making nondeductible IRA contributions gives you another savings option for retirement if appropriately tracked. You should always consult with your tax advisor before withdrawing from your IRA. Knowing your total nondeductible contributions, your accountant will advise on what percentage of your distributions you should withhold for taxes. We also recommend that you contact Aevitas if you plan to make an IRA contribution. You still have the opportunity to make your 2020 tax-year contribution before the filing deadline on April 15, 2021. The annual limit is $6,000 ($7,000 for age 50 and over).