Most people use traditional IRAs to make deductible contributions that result in immediate tax breaks. However, some taxpayers aren't eligible for deductions on their traditional IRA contributions because of having too much income. Any taxpayer can make a nondeductible contribution to a traditional IRA, but doing so has complicated tax consequences that require careful consideration. Let's look more closely at exactly how distributions from nondeductible IRAs get taxed.

Nondeductible IRAs and tax basis
With most traditional IRAs, the tax consequences are simple: All distributions are taxable. That's because if you get an up-front deduction on your IRA contribution, then the IRS wants to get its tax revenue back when you withdraw money from your account in retirement. Put another way, since there's no after-tax money in the account, there's no reason not to go ahead and tax your distributions in retirement.

With nondeductible contributions, though, it gets trickier. Essentially, nondeductible IRAs include some after-tax money, and the IRS gives you credit for the fact that you already paid tax on that portion of the IRA. At the same time, it needs to collect taxes on the portion of the IRA that came from the income and gains that your nondeductible contribution generated between the time you made it and the time you made the withdrawal.

Fortunately, the rules that govern this process are as simple as the situation allows. The IRS essentially treats each distribution you make as being partially from the nondeductible contribution you initially made and partially from the income and gains it generated. To figure how much comes from which part, you have to track how much of your total IRA balance came from nondeductible contributions and how much came from income, and then take the correct proportion from each.

A simple example should make it clearer. Say you contribute $5,000 to a nondeductible IRA. Over the course of five years, it grows to $8,000. You retire and take a distribution of $2,000. To figure out how much is taxable, you can see that $5,000 out of $8,000 in the account came from the original contribution, which works out to five-eighths of its total value. So five-eighths of $2,000, or $1,250, will be free of tax. The remaining $750 represents the three-eighths of the account that came from income and gains, and it gets included in your taxable income.

The key, though, is that you have to keep track of contributions and distributions for future years as well. Unless you clean out the account in one fell swoop, nondeductible IRAs require an accounting hassle that deductible IRAs avoid.

Even with the extra hassle, nondeductible IRAs can make sense in certain situations. By remembering to treat a portion of your distributions as coming from your original nondeductible contribution, you'll ensure that you won't get unfairly double-taxed on your withdrawals in retirement.

If all of this makes you realize that you're missing out and need an IRA, the Fool has a great section where you can learn about IRAs and figure out which one is right for you.

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