8.6 Nondeductible Contributions to Traditional IRAs
If you are not allowed to deduct any IRA contributions for 2012 because of the phaseout rule (8.4), you may make nondeductible contributions of up to $5,000 ($6,000 if age 50 or over at the end of 2012) where you have compensation of at least that much. If the deduction limit is reduced under the phaseout rules (8.4), you may make a nondeductible contribution to the extent the maximum contribution limit of $5,000 (or $6,000) exceeds the deductible limit (8.4).
If you make contributions to a traditional IRA during the year, you may not know whether your active participation status (8.5) and modified adjusted gross income (MAGI) will permit you to claim a deduction under the phaseout rules in 8.4. You can make your contribution and wait until you file your return to determine if you are eligible for a deduction. Assume that you make a contribution and after the end of the year you determine that you are eligible for only a portion of the deductible amount under the phaseout rule (8.4). In that case, you can leave the nondeductible portion in a nondeductible traditional IRA (reporting it on Form 8606), or you may recharacterize (8.22) the nondeductible contribution as a Roth IRA contribution assuming you qualify to contribute to a Roth IRA (8.20). On the other hand, you may decide to withdraw the nondeductible contribution as discussed below.
Roth IRA alternative.
If you are not barred from making Roth IRA contributions (8.20) because of your income level, the Roth IRA has advantages over the nondeductible traditional IRA. Although both types of plans allow earnings to accumulate tax free until withdrawal, the Roth IRA has advantages at withdrawal. After a five-year period, completely tax-free withdrawals of earnings as well as contributions may be made from a Roth IRA if you are age 59½ or older, you are disabled, or you withdraw no more than $10,000 for first-time home-buyer expenses. Even within the first five-year period, contributions may be withdrawn tax free from a Roth IRA. On the other hand, withdrawals from a nondeductible traditional IRA are partially taxed if any deductible contributions to any traditional IRA were previously made. Even if only nondeductible contributions had been made, earnings from traditional IRAs are taxed at withdrawal. Furthermore, contributions after age 70½ may be made only to a Roth IRA, and mandatory required minimum distributions are not required from a Roth IRA, as they are from a traditional IRA. See the discussion of Roth IRAs in this chapter (8.19–8.24).
Planning Reminder
Form 8606.
If you made a nondeductible contribution to a traditional IRA for 2012, you must report it on Form 8606 unless you withdraw the contribution as discussed below. You must list on Form 8606 the value of all of your IRAs as of the end of the year, including amounts based on deductible contributions. If you are married and you and your spouse both make nondeductible contributions, you must each file a separate Form 8606. A $50 penalty may be imposed for not filing Form 8606 unless there is reasonable cause. Furthermore, if you overstate the amount of designated nondeductible contributions made for any taxable year, you are subject to a $100 penalty for each such overstatement unless you can demonstrate that the overstatement was due to reasonable cause. You may file an amended return for a taxable year and change the designation of IRA contributions from deductible to nondeductible or nondeductible to deductible.
Planning Reminder
Withdrawing nondeductible contributions.
If you make an IRA contribution for 2011 and later realize it is not deductible, you may make a tax-free withdrawal of the contribution by the filing due date (plus extensions), instead of designating the contribution as nondeductible on Form 8606. To do this, you must also withdraw the earnings allocable to the withdrawn contribution and include the earnings as income on your 2012 return. You might want to make the withdrawal if you incorrectly determined that a contribution would be deductible and you do not want to leave nondeductible contributions in your account. However, making the withdrawal could subject you to bank penalties for premature withdrawals, or other withdrawal penalties imposed by the IRA trustee. Furthermore, if you are under age 59½, the 10% premature withdrawal penalty applies to the withdrawn earnings unless one of the exceptions (8.12) is available.