At first glance, nondeductible traditional individual retirement account contributions appear to nullify the benefits of contributing. However, those nondeductible contributions come in handy when you're converting to a Roth IRA. In addition, making nondeductible contributions to a traditional IRA might allow you to get money into a Roth IRA when you're ineligible to contribute directly.
If you've made nondeductible contributions to a traditional IRA, you'll end up with a smaller tax bill when you convert all or a portion of your account to a Roth IRA. When you convert your entire traditional IRA balance to a Roth IRA, the nontaxable portion equals the amount of nondeductible contributions in the account. If you convert less than your entire balance, you have to calculate the nontaxable portion; you can't simply choose to convert only the nondeductible contributions.
Determining the Nontaxable Portion
To calculate the nontaxable portion of your conversion, you need to know the amount of nondeductible contributions in the account, the value of your account at the time of the conversion and how much you're converting. First, divide your nondeductible contributions by the value of the account when you convert to determine the portion of nondeductible contributions. Then, multiply the result by the amount of your conversion to calculate the nontaxable portion of the conversion. For example, say you have $20,000 of nondeductible contributions in your IRA worth $80,000 and you're converting $30,000. Divide $20,000 by $80,000 to get 0.25. Then, multiply 0.25 by $30,000 to determine that $7,500 of the conversion is tax-free.
When you file your taxes with the conversion, you must use Part II of Form 8606 to determine the taxable and nontaxable portions of your conversion. Then, report the total conversion on line 15a of Form 1040 or line 11a of Form 1040 and the taxable portion on line 15b of Form 1040 or line 11b of Form 1040A. If you did a rollover and had money withheld for taxes, report that on line 62 of Form 1040 or line 36 of Form 1040A. If you're not sure, check box 4 of Form 1099-R that shows your distribution.
Back Door to a Roth IRA
If you earn too much to contribute directly to a Roth IRA -- in the 2012, modified adjusted gross income limits are $125,000 for single filers and $183,000 for married couples filing jointly -- you can make nondeductible contributions to a traditional IRA and then immediately convert. Granted, if you already have a significant traditional IRA balance from deductible contributions and earnings, this won't work as well because you can't choose to convert only the nondeductible contributions. However, if you don't have an existing traditional IRA account, making a nondeductible contribution and then converting to a Roth IRA has the same impact as contributing directly to a Roth.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."