Nondeductible IRAs

Contribution Limit

The contribution limit for both 2009 and 2010 are the lesser of qualifying income or $5,000.  Qualifying income is defined as earned income reported on W-2, self-employment income or alimony; or Spouses qualifying income over and above amount considered for spouse’s IRA.  Individuals who are age 70½ or older by end of applicable tax year are not eligible.

The catch-up contribution limit, for individuals who are age 50 or will become age 50 at anytime within the tax year (even if you turn 50 on December 31) for both 2009 and 2010, is $1,000.

Who is eligible to contribute to a Nondeductible IRA?

All tax payers, including those who are “active” with qualifying income exceeding the deduction limits above, are eligible to contribute to a nondeductible IRA; however…  As discussed below, the rules for distributions from nondeductible IRAs differ from those that apply to traditional pre-tax IRAs.  See: Pre-tax IRAs

Nondeductible IRA Distributions

Distributions from nondeductible IRAs are taxed on a pro-rata basis considering that the gains on the after-tax investments are taxable, and the principal amount of the after-tax contributions (“the basis”) are tax-free.  However…  when calculating the tax, one must aggregate any after-tax (nondeductible) contributions with all other contributions (or rollovers) in any other IRA accounts (not accounts in a qualified retirement plan).

Example 1:

Individual has:

- $50,000 in IRA 1 of which $30,000 is after-tax contributions

- $100,000 in IRA 2 of which $0 is after-tax

What portion of a $50,000 distribution is taxable?

$30,000 (after-tax contribution)/$150,000 (total in all IRAs) = 20% of distribution is tax-free; therefore…

20% x $50,000 = $10,000 tax-free and $40,000 is taxable

Example 2:

Individual has:

- $50,000 in IRA 1 of which $30,000 is after-tax contributions

- $550,000 in IRA 2 of which $0 is after-tax

What portion of a $50,000 distribution is taxable?

$30,000 (after-tax contribution)/$600,000 (total in all IRAs) = 5% of distribution is tax-free; therefore…

5% x $50,000 = $2,500 tax-free and $47,500 is taxable

Planning Tip  Individuals who have multiple nondeductible IRAs (especially those high net worth individuals who plan to convert them to Roth IRAs in 2010 or beyond) should try to move any pre-tax IRA assets (like the $550,000 in example 2 above) into an employer sponsored qualified retirement plan (this applies to owner-only businesses or self-employed individuals who sponsor a qualified retirement plan).  If the individual moves the $550,000 into his employer’s qualified retirement plan, the outcome is as follows…

Example 3:

Individual has:

- $50,000 in IRA 1 of which $30,000 is after-tax contributions

What portion of a $50,000 distribution (or conversion) is taxable?

$30,000 (after-tax contribution)/$50,000 (total in all IRAs) = 60% of distribution is tax-free; therefore…

60% x $50,000 = $30,000 tax-free and $20,000 is taxable

Suggested reading: A Roth Conversion Loophole You Can Use 

Required Minimum Distributions (RMDs)

Individuals are required to take minimum distributions in accordance with applicable rules from all pre-tax and nondeductible IRAs upon attainment of age 70½.

Copyright © 2009 Barry R. Milberg   All Rights Reserved

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