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.
Broadly, IRAs are generally considered as either deductible or nondeductible. 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.
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). 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.
What Does Nondeductible Mean?
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. 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.
What Are the 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 (70 1/2 in 2019), 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 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. It is important to keep track of which portions of an IRA are nondeductible to avoid double taxation for the account holder and any potential inheritors or beneficiaries.
How Has the CARES Act Impacted IRA Rules?
The coronavirus pandemic led to the passing of the Coronavirus Aid Relief and Economic Security Act, also known as the CARES Act. The required minimum distributions have been waived for 2020. Inherited IRAs will not require distributions either, and 2020 will not count toward the five-year maximum before fully distributing the IRA as there are no required distributions in 2020. Repaid distributions that were required will not count toward the limit on rollovers.
Distributions that are related to the coronavirus are allowed up to $100,000 and will not be penalized. There are no mandatory withholdings on coronavirus-related distributions; taxes due may be paid across three years or in the year the distribution was taken. Coronavirus-related distributions that are eligible for tax-free rollovers may be re-contributed within three years of the distribution.
- IRS: Coronavirus Relief for Retirement Plans and IRAs
- IRS: Retirement Topics — Required Minimum Distributions (RMDs)
- IRS: Form 8606
- IRS: Form 5329
- IRS: About Form 1099-R
- Internal Revenue Service (IRS). "IRA Year-End Reminders." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "Retirement Topics - Catch-Up Contributions." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "Retirement Topics - IRA Contribution Limits." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "Retirement Plan and IRA Required Minimum Distributions FAQs." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "2020 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions If You ARE Covered by a Retirement Plan at Work." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "Amount of Roth IRA Contributions That You Can Make for 2020." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "About Form 8606, Nondeductible IRAs." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "Publication 590-B (2019), Distributions from Individual Retirement Arrangements (IRAs)." Accessed April 3, 2020.
- Internal Revenue Service (IRS). "Form 8606: What Records Must I Keep?" Page 6. Accessed April 3, 2020.
Hashaw Elkins is a financial services professional and project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw is further certified in organizational change management, diversity management, and cross-cultural mediation.