The point of having a traditional IRA is to deposit money for retirement in the account and not pay tax on the money until you withdraw it. Normally, you deduct whatever you deposit in your IRA from your taxable income on your 1040. In some cases, however, you might make non-deductible contributions. Rather than deducting these contributions from taxable income, you pay tax on them now rather than later.
Normally, you can deposit up to $5,000 tax-free -- as of 2012 -- in an IRA . If you also have a tax-deductible employee account, such as a 401(k), the rules change as your income rises. In 2012, for example, if you're a single tax filer making more than $58,000 you can't deduct the full $5,000: You can put $5,000 in, but some of it stays taxable. The exact amount depends on your income: The more you make, the less you can deduct, and above a certain point you can't deduct anything.
Even if your IRA deposit isn't tax-deductible, any interest it earns in the IRA is tax-free until you withdraw the money. If your IRA is earning good returns, that may be a good enough reason to make non-deductible contributions. If you make IRA contributions throughout the year and your income isn't consistent -- you work on commission, for instance -- you may not know some of your contributions are non-deductible until December 31 when you discover how much your income was for the year.
If you pay tax on your IRA contributions, you don't have to pay tax again when you withdraw them. If you deposit $22,000 in non-deductible contributions over the life of your IRA, you can withdraw it tax-free in retirement. Unfortunately, you can't pick and choose, for example making only tax-free withdrawals in a given year. Instead, you use a percentage: If 12 percent of your contributions were non-deductible, roughly 12 percent of your withdrawals are tax free.
It's your responsibility, not your account manager's, to figure out how much of your IRA contributions for the year are non-deductible. Use IRS Form 8606 to record and report how much of your contribution you had to pay tax on this year. You also use the form to track your cumulative non-deductible contributions from year to year. Keep the forms in your records: The IRS will treat everything you withdraw as taxable unless you have proof that you've paid tax on some of the money already.
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