If you are not eligible to contribute to a Roth or make a deductible contribution to a traditional IRA because your income is too high or you participate in a company retirement plan, you may choose to make nondeductible contributions to a traditional IRA. The only requirement for nondeductible contributions is that you have earned income. In 2010, the IRS began allowing taxpayers to convert traditional IRA balances to Roth accounts. This includes nondeductible contributions, as long as you pay the appropriate taxes on the conversion.
If you convert your non-deductible IRA contributions to a Roth IRA account, you will probably owe some taxes on this conversion. While the non-deductible contributions portion will not incur a taxable event, any gains will be taxable. You must figure contributions to gains proportionately. For example, if you are going to convert a non-deductible IRA that contains $10,000 in contributions and $10,000 in investment gains, 50 percent of that account is investment gains, therefore, 50 percent of the $20,000 conversion is taxable.
Taxed at Income Rates
The taxes due on the converted non-deductible IRA are calculated at the rate for your normal income. If you are in the 25 percent tax bracket, and you owe taxes on $10,000 of your conversion, you will pay $2,500 in federal taxes as normal income tax.
The biggest advantage to converting a non-deductible IRA to a Roth and taking the tax-hit for the conversion, is that all of the future gains on the account are non-taxable when you withdraw the money at retirement age. This is a substantial benefit, and for many, makes it worth it to do the conversion as soon as possible.
Backdoor Roth IRA
You can also use the non-deductible IRA as a way to fund a Roth IRA if you are not allowed to contribute to a Roth because your adjusted gross income exceeds the maximum allowed. No income requirements exist to convert a non-deductible IRA. By making a non-deductible contribution to an IRA and immediately converting that contribution to a Roth, you can fund a Roth IRA if you would not otherwise qualify.