Before the invention of Roth IRAs, many people who didn't qualify to make deductible IRA contributions made nondeductible ones instead. In some cases, their contributions may have been partially deductible.
Some taxpayers still make nondeductible IRA contributions if their income levels prevent them from making deductible traditional IRA or Roth IRA contributions.
Downsides of nondeductible traditional IRAs
For most taxpayers nowadays, Roth IRAs are a far better deal than nondeductible traditional IRAs. Roth IRAs allow you to make nondeductible contributions now and take out contributions and earnings tax-free at retirement. On the other hand, with nondeductible contributions to traditional IRAs, you take your contributions out tax-free at retirement, but you pay tax on the earnings. Roth IRAs are thus the better deal -- no contest. (Deductible contributions to traditional IRAs, of course, lower your taxable income for the year you make the contributions. When you take withdrawals in retirement, they are fully taxable.)
Another downside of nondeductible traditional IRAs is that you must figure out what amount of any withdrawal comes from deductible contributions and earnings and how much comes from nondeductible contributions.
This can be a daunting task. You'd think that so long as you kept nondeductible and deductible contributions in separate accounts, you'd have it made. Not so, according to the Internal Revenue Service.
The IRS considers all your traditional IRAs to be one big IRA. If you have any deductible IRAs, and you take withdrawals from a nondeductible or partially deductible IRA, you must use proportionate allocation rules to determine how much of your withdrawal comes from nondeductible contributions. These rules are in IRS Publication 590, Individual Retirement Arrangements.
What to do with your nondeductible IRA
If you have a nondeductible IRA, you can deal with it in three different ways:
1. Do a Roth IRA conversion
Currently, anyone can convert a traditional IRA to a Roth IRA, regardless of income level. A Roth IRA conversion is basically just moving funds from a traditional IRA to a Roth IRA. To convert your account, you can take a distribution from the traditional IRA and then contribute it to the Roth IRA, or you can simply do a direct trustee-to-trustee transfer without actually handling the money yourself. If the brokerage or other trustee that handles your traditional IRA also offers a Roth IRA, that trustee can transfer funds from one account to the other.
If you're planning to convert to a Roth IRA, you may want to do that sooner rather than later. For one thing, you'll benefit more from the tax-free earnings in a Roth IRA if you make the conversion sooner. In addition, there have been rumblings about restricting high-income individuals from converting to Roth IRAs in the future.
2. Make withdrawals from your nondeductible IRA
If you're over age 59-1/2, or if you meet any exceptions to a penalty for early withdrawal from IRAs, consider withdrawing the money in your IRAs. This is a practical solution if your IRAs are small compared to your other investments and retirement plans. It may also be a good idea if you were already planning to take withdrawals from one of your retirement plans.
You'll have to pay tax on any earnings, gains, and the portion that is considered to be from deductible contributions. You cannot simply withdraw the nontaxable portions first. For each withdrawal you make, part of it is a nontaxable return of your nondeductible contributions, and part of it is a taxable withdrawal of deductible contributions, earnings, and gains.
You can minimize the damages by choosing to take withdrawals in a year when you are in a lower tax bracket or by taking the withdrawals over two or more years. Or you can increase your deductible contributions to other retirement plans, such as your deductible 401(k) plan at work, to compensate.
If you withdraw from your traditional IRA and then contribute to a Roth IRA within 60 days, it is considered to be a conversion.
3. Leave it alone for now
In most cases, leaving a balance in your nondeductible traditional IRA for an indefinite time is the least satisfying option. The Roth IRA, after all, is so much more preferable.
However, if only a small portion of your traditional IRA consists of nondeductible contributions, it may not be worth the trouble to convert to a Roth IRA. The IRS does not allow you to convert only the nondeductible portion.
You may also want to leave your nondeductible IRA alone if you're planning to do a so-called "backdoor" Roth IRA. A backdoor Roth IRA is a strategy of making nondeductible contributions to a traditional IRA when a person does not qualify to make Roth IRA contributions, and then converting the traditional IRA to a Roth IRA.
Caution: If you're planning to roll over assets from a 401(k) plan or other retirement plan into an IRA, and you have a nondeductible traditional IRA, even in a different account, be careful. You may want to roll over your nondeductible traditional IRA into a Roth IRA first, for example.
Nondeductible traditional IRAs are becoming more rare, but they still exist. In some cases, nondeductible contributions to traditional IRAs still make sense. Be sure you understand how the rules for nondeductible and partially deductible IRAs work, so your retirement accounts give you all the tax benefits to which you are entitled.