- Contribution limits: The annual contribution limit for nondeductible IRAs is the same as for other IRAs. Contributions to a nondeductible IRA, on the other hand, are made after-tax monies, whereas contributions to a regular IRA or 401(k) are tax deductible in the year they are made.
- Withdrawing contributions: In retirement, you can withdraw money from a nondeductible IRA without paying taxes on it. Otherwise, their contributions would be taxed twice. However, you must disclose your nondeductible IRA contributions each year on IRS Form 8606 to let the IRS know that you made them using after-tax cash. This form is required to ensure that you are not taxed twice on the money you contributed when you withdraw it in retirement.
- Withdrawing investment gains: Withdrawals on investment gains are taxed at your regular income tax rate. Nondeductible IRAs do not offer the same tax-free profit withdrawals as a Roth IRA or Roth 401(k).
Are earnings on non-deductible IRA taxable?
A tax deduction is not available for a nondeductible IRA contribution. You’ll pay taxes on the money you put into the account, as the name implies. The earnings in the account, on the other hand, will not be taxed until they are withdrawn. “Half a loaf is better than none,” Whitney says of a nondeductible IRA. “You don’t get a tax credit on your income taxes in the years you contribute, but the money you put into the account grows tax-free.”
How is an IRA taxed at withdrawal?
- Traditional IRA contributions are tax deductible, gains grow tax-free, and withdrawals are income taxed.
- Withdrawals from a Roth IRA are tax-free if the account owner has held it for at least five years.
- Roth IRA contributions are made after-tax dollars, so they can be withdrawn at any time for any reason.
- Early withdrawals from a traditional IRA (before age 591/2) and withdrawals of earnings from a Roth IRA are subject to a 10% penalty plus taxes, though there are exceptions.
Can you make a non-deductible IRA contribution without earned income?
If you file a joint return and your modified adjusted gross income exceeds $92,000 (as of 2012), the IRS will limit your tax-free contributions if you also have a 401k or similar work account. None of your IRA contributions are tax-free once you reach $112,000 in earnings. If your earned income is less than $5,000, you are subject to an additional restriction: you cannot give more money than you earn, regardless of taxes. If you don’t have any earned income this year, you won’t be able to contribute to your IRA at all.
What is the maximum non-deductible IRA contribution?
That isn’t a big deal, but it does make things easier if you make your complete year’s contribution at once and then convert it. (In 2020, the maximum IRA contribution is $6,000, or $7,000 if you’re 50 or older; in 2019, the restrictions remained the same.) If you want to repeat this strategy next year, you may usually leave the nondeductible IRA open, though be sure your account provider doesn’t impose a minimum amount.
How do I figure the taxable amount of an IRA distribution?
The taxable amount of an IRA withdrawal might vary dramatically depending on the type of IRA account you own, when you made your withdrawal, and if your contributions were deductible. Here’s how to figure out how much of a withdrawal from a regular or Roth IRA will be taxed.
If you made all of your conventional IRA contributions tax-deductible, the computation is simple: all of your IRA withdrawals will be considered taxable income.
The computation becomes a little more tricky if you made any nondeductible contributions (which is uncommon).
To begin, determine how much of your account is comprised of nondeductible contributions. The nondeductible (non-taxable) component of your traditional IRA account is calculated by dividing the total amount of nondeductible contributions by the current value of your traditional IRA account.
The taxable portion of your traditional IRA is calculated by subtracting this amount from 1.
Spouses get the most leeway
If a survivor inherits an IRA from their deceased spouse, they have numerous options for how to spend it:
- Roll the IRA over into another account, such as another IRA or a qualified employment plan, such as a 403(b) plan, as if it were your own.
Depending on your age, you may be compelled to take required minimum distributions if you are the lone beneficiary and regard the IRA as your own. However, in certain instances, you may be able to avoid making a withdrawal.
“When it comes to IRAs inherited from a spouse, Frank St. Onge, an enrolled agent with Total Financial Planning, LLC in the Detroit region, says, “If you were not interested in pulling money out at this time, you could let that money continue to grow in the IRA until you reach age 72.”
Furthermore, couples “are permitted to roll their IRA into a personal account. That brings everything back to normal. They can now choose their own successor beneficiary and manage the IRA as if it were their own, according to Carol Tully, CPA, principal at Wolf & Co. in Boston.
The IRS has more information on your options, including what you can do with a Roth IRA, which has different regulations than ordinary IRAs.
Choose when to take your money
If you’ve inherited an IRA, you’ll need to move quickly to prevent violating IRS regulations. You can roll over the inherited IRA into your own account if you’re the surviving spouse, but no one else will be able to do so. You’ll also have several more alternatives for receiving the funds.
If you’re the spouse of the original IRA owner, chronically ill or disabled, a minor kid, or not fewer than 10 years younger than the original owner, you have more alternatives as an inheritor. If you don’t fit into one of these groups, you must follow a different set of guidelines.
- The “stretch option,” which keeps the funds in the IRA for as long as feasible, allows you to take distributions over your life expectancy.
- You must liquidate the account within five years of the original owner’s death if you do not do so.
The stretch IRA is a tax-advantaged version of the pot of gold at the end of the rainbow. The opportunity to shield cash from taxation while they potentially increase for decades is hidden beneath layers of rules and red tape.
As part of the five-year rule, the beneficiary is compelled to take money out of the IRA over time in the second choice. Unless the IRA is a Roth, in which case taxes were paid before money was put into the account, this can add up to a colossal income tax burden for large IRAs.
Prior to 2020, these inherited IRA options were available to everyone. With the passage of the SECURE Act in late 2019, persons who are not in the first category (spouses and others) will be required to remove the whole balance of their IRA in 10 years and liquidate the account. Annual statutory minimum distributions apply to withdrawals.
When deciding how to take withdrawals, keep in mind the legal obligations while weighing the tax implications of withdrawals against the benefits of letting the money grow over time.
More information on mandatory minimum distributions can be found on the IRS website.
Be aware of year-of-death required distributions
Another challenge for conventional IRA recipients is determining if the benefactor took his or her required minimum distribution (RMD) in the year of death. If the original account owner hasn’t done so, the beneficiary is responsible for ensuring that the minimum is satisfied.
“Let’s imagine your father passes away on January 24 and leaves you his IRA. He probably hadn’t gotten around to distributing his money yet. If the original owner did not take it out, the recipient is responsible for doing so. If you don’t know about it or fail to do it, Choate warns you’ll face a penalty of 50% of the money not dispersed.
Not unexpectedly, if someone dies late in the year, this can be an issue. The deadline for taking the RMD for that year is the last day of the calendar year.
“If your father dies on Christmas Day and hasn’t taken out the distribution, you might not even realize you own the account until it’s too late to take out the distribution for that year,” she explains.
There is no year-of-death compulsory distribution if the deceased was not yet required to take distributions.
Take the tax break coming to you
Depending on the form of IRA, it may be taxable. You won’t have to pay taxes if you inherit a Roth IRA. With a regular IRA, however, any money you remove is taxed as ordinary income.
Inheritors of an IRA will receive an income tax deduction for the estate taxes paid on the account if the estate is subject to the estate tax. The taxable income produced by the deceased (but not collected by him or her) is referred to as “income derived from the estate of a deceased person.”
“It’s taxable income when you receive a payout from an IRA,” Choate explains. “However, because that person’s estate had to pay a federal estate tax, you can deduct the estate taxes paid on the IRA from your income taxes. You may have $1 million in earnings and a $350,000 deduction to offset that.”
“It doesn’t have to be you who paid the taxes; it simply has to be someone,” she explains.
The estate tax will apply to estates valued more than $12.06 million in 2022, up from $11.70 million in 2020.
Don’t ignore beneficiary forms
An estate plan can be ruined by an ambiguous, incomplete, or absent designated beneficiary form.
“When you inquire who their beneficiary is, they believe they already know. The form, however, hasn’t been completed or isn’t on file with the custodian. “This causes a slew of issues,” Tully explains.
If no chosen beneficiary form is completed and the account is transferred to the estate, the beneficiary will be subject to the five-year rule for account disbursements.
The form’s simplicity can be deceiving. Large sums of money can be directed with just a few bits of information.
Improperly drafted trusts can be bad news
A trust can be named as the principal beneficiary of an IRA. It’s also possible that something terrible will happen. A trust can unknowingly limit the alternatives available to beneficiaries if it is set up wrongly.
According to Tully, if the trust’s terms aren’t correctly crafted, certain custodians won’t be able to look through the trust to establish the qualified beneficiaries, triggering the IRA’s expedited distribution restrictions.
According to Choate, the trust should be drafted by a lawyer “who is familiar with the regulations for leaving IRAs to trusts.”
Do you have to pay taxes on an IRA after 70?
You own the entire amount in your traditional IRA. You can take any part or all of your conventional IRA assets out at any time for any reason, but there are tax implications. All withdrawals from a traditional IRA are taxed as regular income the year they are made. The Internal Revenue Service imposes a 10% tax penalty if you withdraw funds before reaching the age of 59 1/2. In the year you turn 70 1/2, you must start taking minimum withdrawals from your conventional IRA. The money you take out at that time is taxed as regular income, but the money you keep in your IRA grows tax-free regardless of your age.
Can I make a nondeductible IRA contribution and convert to Roth?
Each year, you can contribute to a nondeductible IRA and then convert it to a Roth IRA utilizing the backdoor strategy. Any converted amount that exceeds your basis at the time of conversion will be taxed. 2 If you have other IRA accounts, you must calculate your base using a pro-rata formula.
Can you make a non-deductible IRA contribution if you have a 401k?
Yes, you can contribute to both a 401(k) and an IRA, but if your income exceeds the IRS limits, you may lose out on one of the traditional IRA’s tax benefits. (You can contribute to an IRA even if you aren’t able to deduct your contribution.) (To learn more about nondeductible IRAs, go here.)
What is the difference between a nondeductible IRA and a Roth IRA?
A Roth IRA will always be as good as or better than a traditional IRA that is not tax deductible. Contributions are after-tax in both circumstances, but a Roth IRA’s future growth and withdrawals are tax-free, but a non-deductible Traditional IRA’s growth withdrawal is taxable as income. The annual contribution limit for both a Roth and a Traditional IRA is the same. A Roth IRA contribution limit exists, although a non-deductible Traditional IRA contribution limit does not. The Backdoor Roth IRA can be used to get around this income limit.
Is a non-deductible IRA worth it?
Because it does not give the same tax benefits as other retirement plans, you should only utilize a nondeductible IRA if you do not qualify for other retirement accounts. Calculate your modified adjusted gross income to see if you’re eligible for a nondeductible IRA (MAGI).
What is a backdoor Roth?
- Backdoor Roth IRAs are not a unique account type. They are Roth IRAs that hold assets that were originally donated to a standard IRA and then transferred or converted to a Roth IRA.
- A Backdoor Roth IRA is a legal approach to circumvent the income restrictions that preclude high-income individuals from owning Roths.
- A Backdoor Roth IRA is not a tax shelter—in fact, it may be subject to greater taxes at the outset—but the investor will benefit from the tax advantages of a Roth account in the future.
- If you’re considering opening a Backdoor Roth IRA, keep in mind that the United States Congress is considering legislation that will diminish the benefits after 2021.