Taxes on traditional IRAs are usually simple: you put pre-tax money in the account, and then you pay taxes when you take money out. When some of your contributions are taxable, figuring your taxes gets more complicated. The triggers that make some or all of your IRA non-deductible include receiving Social Security benefits, being covered by a workplace plan and having a high adjusted gross income.
Use the worksheets in IRS Publication 590 to figure out how much of your IRA contributions are taxable this year. You report your non-deductible contributions on Form 8606; when you make out your 1040, you only subtract the deductible amounts from your taxable income. The non-deductible contributions are taxed just like the rest of your regular income. Get the calculations right, because your account administrator doesn't track how much of your contribution is taxable.
Once the non-deductible contributions are in your account, they earn interest tax-free, like regular contributions. When you make withdrawals, all the money you've already paid tax on is now tax-free, though the earnings generate income tax. To figure out how much of each withdrawal is tax-free, you have to do more math. If, for example, you have two traditional IRAs and 12 percent of the contents consist of non-deductible contributions, 12 percent of every withdrawal is tax-free.
The government taxes IRA withdrawals at the same rate as ordinary income -- which, financial planner Jim Blankenship suggests, makes non-deductible contributions a bad deal. You don't get a tax break when you put the money in, and the tax on withdrawals is higher than if you invested in something subject to capital gains tax. When you hold an investment for longer than a year, capital gains pays a lower tax rate than regular income. If you can't deduct any of your IRA contributions, Blankenship suggests you look elsewhere for retirement investing.
Normally you pay a 10 percent penalty if you take money out of an IRA before you turn 59 1/2. This doesn't apply to non-deductible contributions: you can take them back out at any age, without penalty, though any earnings you withdraw are taxable. If you roll over your IRA into a Roth IRA, you pay income tax that year just as if you'd withdrawn all your IRA assets at once but no tax penalty. Again, the non-deductible contributions are not taxed.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.