If your annual income is above a certain threshold, you may not be able to deduct contributions to your traditional individual retirement account (IRA) from your taxable income. You might only be able to set aside a certain amount of money each year, but you can still put money away for your retirement by making contributions that aren’t tax-deductible.
It is possible to postpone paying your taxes on the earnings and growth of your savings, just as it is possible to do with the rest of the money you have saved there. However, your nondeductible contributions will not have any effect on the portion of your income that is subject to taxation in the year that you make them.
IRA Contributions Are an Investment in Your Future
Even if you do not immediately receive a tax break for your savings, the growth in your savings can potentially be very good. If you anticipate paying a lower effective tax rate after you retire compared to what it is now, making this contribution could be beneficial to you in the long run. If you anticipate both an increase in your income and your tax rate in the future, it is possible that you will find it more beneficial to pay taxes on earnings as they are earned rather than deferring taxation until a later time.
When you take distributions from your standard IRA during retirement, you will be subject to taxes on the growth of the account; however, any savings that you did not deduct will be considered part of your basis in the asset. You already made a tax payment on that money when you saved it, so you won’t have to make another tax payment on it in the future.
The Internal Revenue Service (IRS) keeps a record of taxpayers who have paid taxes on savings that are not tax-deductible by requiring them to submit Form 8606 with their tax returns.
Let’s say that twelve months ago, you made a contribution of $2,000 that you either chose not to deduct or were unable to do so. As a result of the tax-deductible contributions you made as well as the growth of your investments, the total balance in your account has grown to $20,000 by the time you make a withdrawal.
Your basis was $20,000 divided by $2,000. This is a return of the portion of your savings that wasn’t deducted when you filed your taxes. Because 10 percent of $2,000 was your basis, only $900 of that money would be considered taxable income to you in this scenario if you were to make a withdrawal of $1,000 during your retirement years.
IRA Contribution Limits and Restrictions
The guidelines for IRA investments can be difficult to understand, and they are updated annually to account for inflation. It is beneficial to examine them on an annual basis.
If you are at least 50 years old in either 2021 or 2022, you will be eligible to contribute a total of $7,000 to traditional, and Roth IRAs combined. If you are under the age of 49 in 2021 or 2022, you will be able to contribute a combined total of $6,000 to both your traditional and Roth IRAs. When funds are rolled over from one account to another or when qualified reservists are reimbursed, these limits do not apply to the transactions.
If you save more money than your yearly limit, the Internal Revenue Service (IRS) will assess an excise tax equal to 6 percent of the excess amount each year until you remove those savings from your account.
Restriction on Contributions Due to Income in IRAs
Suppose you are hired by a company which provides a workplace retirement account, such as a 401(k) or 403(b). In that case, you may not be able to deduct the full amount that you contribute to a standard individual retirement account (IRA). This is because you are subject to certain income limits (b). This is the case regardless of whether or not you choose to take part in the plan offered at your place of employment. These maximum amounts of adjusted gross income (AGI) go up by a small amount every year in order to account for inflation.
If you are filing your taxes as a single person or as the head of a household in 2021, and your adjusted gross income is $66,000 or less, you can claim the full deduction. For the tax year 2022, that amount will be raised to $68,000.
You are also eligible to claim the full deduction if you are married and filing your taxes jointly, if you are a qualifying widower, and if your adjusted gross income is $105,000 or less in 2021 or $109,000 or less in 2022. If you are married and filing jointly in 2021, and a plan covers your spouse through work, but you are not, then you are eligible to take the full deduction. Your AGI must be at or below $198,000 for this to be the case. When 2022 rolls around, this threshold will be raised to $204,000.
If you are married but filing your taxes separately, and your adjusted gross income is less than $10,000, you are only eligible for a portion of the standard deduction.
If you are married but filing your taxes separately, you are subject to more stringent income rules. As your income increases, certain deductions will begin to be eliminated from these thresholds. However, the Internal Revenue Service will treat you as a single-payer for the purposes of these limits if you have lived apart from your spouse throughout the entire tax year.
Suppose neither you nor your spouse is eligible to take part in a retirement plan through your place of employment. In that case, it may be possible that you are still eligible to make tax-deductible contributions to an individual retirement account (IRA). It makes no difference how much money you make.
As an Alternative, There Is the Roth IRA
The income thresholds for Roth IRAs are significantly higher. If you are covered by an employer-sponsored 401(k) and your income is higher than the limits for a regular IRA deduction, you may still be able to save to a Roth IRA. This is the case even if you have exceeded the limits for a regular IRA deduction.
In situations like this one, it is typically more prudent to make a contribution to a Roth IRA rather than a nondeductible IRA contribution. Both of these retirement accounts do not qualify for a tax deduction; however, with a traditional IRA, the tax on the savings is deferred (meaning that you will pay taxes on the money at a later date). With a Roth IRA, the savings grow tax-free.
Making Contributions to Your IRA That Are Not Tax Deductible –– the bottom line
Identifying the financial strategy that will provide you with the greatest return on investment can be an ongoing process. It is possible for it to depend on your age, your income, and the objectives you have for your retirement. You should seek the assistance of a specialist in order to determine the most effective strategy for accumulating tax-favored savings.
Frequently Asked Questions (FAQs)
How can one make a contribution to my IRA that is not tax-deductible?
When you file your annual tax return, you will need to report any contributions to your IRA that are not tax-deductible using IRS Form 8606.
What is the maximum amount that one can contribute to a nondeductible IRA?
You are allowed to contribute a maximum amount of $6,000 per year to all of your IRA accounts combined, increasing to $7,000 if you are 50 years old or older; however, the amount you can contribute cannot exceed your total taxable income. The limit is the same whether you contribute to a traditional or Roth IRA, and it also applies regardless of whether or not your contributions are tax-deductible.