Tax Consequences of a Nondeductible IRA Distribution

Individual retirement accounts (IRAs) are a great way to save for the future. There are many types of retirement accounts, which are subject to specific tax rules and regulations for contributions and distributions.

Deductible vs. Nondeductible IRA

Broadly, IRAs are generally considered as either a deductible IRA or non-deductible IRA. Nondeductible IRAs have some unique features that make them an attractive option for individuals. However, it is important to be aware of the tax implications of these unique features.

1. What Types of Retirement Accounts Exist?

There are traditional IRAs, nondeductible IRAs and Roth IRAs, which all share commonalities for contribution limits. Other accounts include 401(k) s, thrift savings plans (TSP) and 403(b) s. These accounts can also be either deductible or nondeductible.

The contribution limits for these types of retirement accounts are typically higher than for IRAs, which are limited to ​$6,000 per year​ for most account holders (if an account holder is over 50, they are allowed to contribute an additional ​$1,000​ catch up for a total of ​$7,000)​. 2021 contribution limits for a 401(k), TSP, or 403(b) are ​$19,500, with an additional ​$6,500​ catch-up.

There are differences for each account type that can be specific to certain industries and employers that can further impact these limits. Regardless of the type of account, early distributions may be assigned a penalty depending on the reason for the distribution. However, the CARES Act has modified many rules around retirement distributions.

2. What Is a Non-Deductible IRA Contribution?

A contribution to an IRA is nondeductible if it is funded with post-tax dollars. This means that taxes have already been paid on the money that is used to contribute to the account. Another popular retirement account that is nondeductible is known as a Roth IRA.

It is important to note that while they are similar, a nondeductible IRA is not the same thing as a Roth IRA. Nondeductible IRAs allow an account to grow without being taxed on dividends or capital gains while the money is invested in the account. The Roth IRA will not be taxed upon qualified distribution, which is why many people elect to convert their nondeductible IRA into a Roth IRA.

What makes an IRA deductible or not is whether taxes are paid prior to the contribution, or if all taxes are paid after distribution. For example, if an IRA contribution comes from wage income, then the entire amount will be taxed as earned income before it goes into an IRA as a nondeductible contribution. On the other hand, if the IRA contribution is deductible (as in the case of a traditional IRA), then the amount of the contribution will be excluded from the contributor's taxable adjusted gross income based on modified adjusted gross income thresholds.

In contrast to a nondeductible contribution, a distribution from the deductible IRA will be fully taxed.

Choosing a deductible or nondeductible IRA is often a matter of estimating income and tax rates that are anticipated during retirement. Nondeductible IRAs are often a choice selected by those with incomes that surpass the income threshold requirements.

3. Rules on Nondeductible IRA Distributions

Under normal circumstances, qualified distributions can be taken when the account holder reaches the age of ​59 1/2​ without incurring a penalty. Once an account holder reaches the age of ​72​, the IRS mandates "required minimum distributions" based on age and IRA value, or a ​50 percent​ penalty will be assigned to insufficient or late distributions.

Distributions that are considered qualified are not subject to the penalty. Distributions from an account holder's basis in the nondeductible IRA can be taken at any time, but any distributions that include account earnings are subject to taxation and a ​10 percent​ penalty.

Most distributions from nondeductible IRAs include a combination of the post-tax contribution combined with taxable account earnings. Account earnings are taxable as the account grows; however, the actual contributed funds are tax-free. Distributions that include account earnings can be taken early if the distribution comes from an account that has been kept for at least ​five years​ and the money (not to exceed ​$10,000​) is used toward a first-time home purchase.

Other qualifying distributions include those related to a disability or to an account beneficiary if the account holder is deceased. Exceptions to the ​10 percent​ penalty may apply if the distribution is to cover medical expenses, federally declared disasters or education expenses.

Reporting Nondeductible IRA Distributions

When a distribution is taken from an IRA, a Form 1099-R is issued. The code in ​box 7​ will indicate whether a penalty is due. It is important to make certain that the reason for any early distribution is clearly communicated. Form 8606 or 5329 will then need to be included when filing taxes for the year of the distribution.

To calculate the taxable portion of an IRA distribution, divide the taxed contribution by the total account value. Keeping track of nondeductible IRA contributions is critical. It will help you to avoid double taxation for the account holder and any potential inheritors or beneficiaries.