One of the most significant enticements to contributing to a traditional individual retirement arrangement is deducting your contributions. However, not everyone is eligible to claim the deduction. Even if you can't claim the deduction, you can still make a nondeductible contribution that might still be worthwhile depending on your income tax situation.
When You Can't Deduct
According to IRS Publication 590, the IRS disallows a deduction for traditional IRA contributions if you or your spouse participates in an employer-sponsored retirement plan and your annual income is too high. If you're not sure if you're covered, look in Box 13 on your Form W-2: if the "retirement plan" box is checked, you're covered. The income limits vary depending on your filing status. If neither you nor your spouse have employer-sponsored plans, you can always deduct your contributions.
When you make a nondeductible contribution, you don't get to reduce your taxable income for the year of the contribution. However, when you take distributions, you split the distribution into two portions, the portion from the nondeductible contributions and the portion from the rest of the account based on the value of the account. For example, if you've made $30,000 of nondeductible contributions to your IRA and the IRA's value equals $50,000, 60 percent of your distribution is tax-free because 60 percent of the account's value comes from nondeductible contributions.
If you make a nondeductible contribution to your traditional IRA, file Form 8606 to report the nondeductible contribution to the IRS. If you fail to file this form, the IRS will treat distributions from the IRA as if you had made a deductible contribution resulting in the money being taxed twice. To avoid the double taxation, you must prove to the IRS that you made a nondeductible contribution and pay a $50 fee for each year you didn't file.
If you qualify, consider making a contribution to a Roth IRA rather than a nondeductible contribution to a traditional IRA. Roth IRA contributions cannot be deducted either, but qualified distributions from Roth IRAs, including earnings, come out tax-free. However, Roth IRAs have income limits that prevent you from contributing if you make too much during the year. If you can't contribute directly to a Roth IRA because of your income, you may be able to make a nondeductible contribution to a traditional IRA and then immediately convert it to a Roth IRA.
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