A non-deductible IRA is a retirement plan that is funded with after-tax money. You can't deduct your income tax contributions like you would with a traditional IRA. However, your non-deductible contributions grow tax-free. Any money that contributes to a traditional IRA and that you don't deduct on your tax return is a “non-deductible contribution”.
You must still declare these contributions on your return and, to do so, you must use Form 8606.A non-deductible IRA is a type of retirement account, similar to a traditional IRA or a Roth IRA. What sets non-deductible IRAs apart is that account contributions don't provide an immediate tax benefit because they're made with after-tax money. There are several reasons why an investor may choose to fund a non-deductible IRA. Since non-deductible IRA contributions are made with after-tax money, this form prevents the IRS from taxing investors twice when the money is withdrawn.
While you avoid annual taxes when you make an after-tax contribution to an IRA, when you make distributions in retirement, the taxable portion will be taxed as ordinary income. In addition, money can be withdrawn from a Roth IRA at any time and for any reason, tax-free and is not subject to minimum withdrawal requirements. Non-deductible traditional IRA contributions are the first step in making clandestine Roth IRA contributions and are most commonly used for this strategy. However, if an investor is covered by an employer's retirement plan (such as a 401k) and earns too much, they may be limited in the amount of their IRA contribution they can deduct.
A Roth IRA would alleviate most problems related to after-tax contributions, but wealthy taxpayers may need to consider converting to Roth, as there are income limits to participating regularly. This allows you to convert a non-deductible IRA into a Roth IRA without having to pay taxes on all of it, but converting to a Roth IRA would require paying taxes on any untaxable profit or gain before it reaches the Roth account. It is not a standalone account type; rather, it is a feature of a traditional IRA that contributions can be deducted from income (subject to income limitations) or not deducted, at the investor's choice. In both cases, contributions are made after tax, but all future growth and withdrawals from a Roth IRA are tax-exempt, while the withdrawal of growth from a traditional non-deductible IRA is subject to taxes as income.
The IRS prorated rule applies to withdrawals from a traditional IRA, SEP or SIMPLE with tax-deductible and after-tax funds (non-deductible and not Roth). The deductibility of IRA contributions is phased out depending on tax reporting status, income (specifically modified adjusted gross income), and whether or not the investor is eligible to participate in a retirement plan at work. Only in unusual situations, in which marginal tax rates are very low today and will be much higher at the time of withdrawal, would it make sense to choose not to deduct contributions, but in these situations there should be a Roth IRA available and it would be a better alternative. Your cost base is the sum of non-deductible contributions to your IRA minus any withdrawals or distribution of non-deductible contributions.
However, any investment gain from a non-deductible IRA will be taxed at the investor's ordinary income tax rate. Any return (interest, dividends, capital gains distributions) on investments within a taxable account is taxable in the year in which they are earned, while a traditional IRA is fully subject to deferred taxes. .