How to Report Non-Deductible Traditional IRA Contributions on Your Tax Return
by Katie Minion
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If you have a traditional Individual Retirement Account (IRA), the rules for reporting your contributions are pretty simple. You can deduct your IRA contributions on Form 1040, Schedule 1, Part II – Adjustments to Income.
However, traditional IRA contributions are not always deductible. Let’s talk about what makes a contribution nondeductible and how to report those contributions on your tax return.
When are traditional IRA contributions nondeductible?
In 2020 and 2021, you can contribute up to $6,000 (or $7,000 if you are 50+) to one or more IRAs. Contributions to traditional IRAs will be deductible, but if you or your spouse are covered by a retirement plan through an employer, your deduction may be limited.
If you have an employer-provided plan, your deduction will be reduced or eliminated if your income exceeds certain thresholds. In 2021, a single taxpayer who has an employer-sponsored retirement plan can only take the full IRA deduction if their modified adjusted gross income (MAGI) is at or below $66,000. The deduction will phase out as MAGI increases and will be eliminated altogether once MAGI reaches $76,000. If a taxpayer is married and filing a joint return with their spouse, their IRA deduction will begin to phase out when MAGI reaches $105,000 and will be eliminated when MAGI reaches $125,000.
The IRA deduction for an individual who is not covered by employer-sponsored retirement plan may still be limited if their spouse has a retirement plan through their employer. In this instance, the individual will begin to lose their IRA deduction once their joint MAGI reaches $198,000 and will receive no deduction if their MAGI reaches $208,000.
The key to remember is that traditional IRA contributions are fully deductible unless you or your spouse have a retirement plan through an employer and you have MAGI over certain deduction thresholds. But even if your IRA contributions are nondeductible, you must still report those contributions on your tax return.
How do I report nondeductible contributions on my tax return?
If any of your contributions are nondeductible, you must report them on Part I of IRS Form 8606. Form 8606 keeps a running tally of nondeductible contributions. This running tally, known as your IRA basis, helps you track how much of your IRA has already been taxed. When you begin taking distributions from your plan in retirement, you will not need to pay taxes on amounts that have already been taxed.
Filing an accurate Form 8606 is in your best interest, not only because it serves as proof that you paid taxes on your contributions, but also because there are penalties for failing to file. The IRS will assess a $50 penalty for each non-filed form and a $100 penalty for each form that overstates nondeductible contributions.
Can you tell me more about IRA basis?
Definitely! Your IRA basis is the running tally of the funds in your IRA account that have already been taxed. You must track and update this amount each year so that when you start taking distributions, you aren’t taxed again on that “basis” portion of your IRA.
Your basis in a traditional IRA is made up of nondeductible contributions and any after-tax funds that have been rolled over from another plan. You’ll keep track of your basis and report it to the IRS on Form 8606.
Can I roll over funds from my employer-provided retirement plan into my IRA?
You certainly can! Most employer-sponsored plans, like 401(k)s and 403(b)s, are pre-tax, which means that you have not yet paid taxes on the contributions you made to those plans. You can roll these amounts into your IRA without paying tax or incurring a penalty. Because these amounts have not yet been taxed, they will not affect your IRA basis.
It’s less common to roll over retirement plans that consist of after-tax contributions simply because most contributions to employer-sponsored plans are made with pre-tax dollars. But if you do happen to have an employer-sponsored plan that you funded with after-tax dollars – like a Roth 401k – you can roll those funds into a Roth IRA without incurring taxes or a penalty. A Roth IRA is separate and distinct from a traditional IRA, but the concept of basis is the same; you must track the basis in your IRA to ensure the IRS doesn’t tax you twice on the same income. Roth IRA basis can also be reported on IRS Form 8606.
What should I do if my IRA contributions are nondeductible?
If you realize that your traditional IRA contributions are not deductible, you can do one of two things. You can either (1) do nothing, which would require you to pay taxes on those contributions now and increase the tax basis in your traditional IRA, or (2) request that your traditional IRA contributions get recharacterized into Roth IRA contributions.
Recharacterizing your traditional IRA contributions into Roth IRA contributions won’t affect your tax position in the current year. Either way, you will owe income taxes today on the money that you contributed to your IRA. But if the main benefit of a traditional IRA – the current-year tax deduction – is no longer available, contributing to a Roth account is likely the better choice. While traditional IRAs grow tax-deferred, earnings in a Roth IRA grow tax-free. If you are over age 59 ½ and have held your Roth IRA for at least five years, earnings within your Roth retirement accounts will never be taxed.
If you would prefer your earnings to grow tax-free rather than tax-deferred, recharacterizing to a Roth IRA is something to consider. But there are a few important things to remember.
- Know the recharacterization deadline. You must recharacterize IRA contributions made in the current tax year by the income tax filing deadline, including extensions.
- Know if you’re eligible to make Roth contributions. High earners are barred from making contributions to a Roth IRA, including contributions made through recharacterizations. Taxpayers cannot contribute to a Roth account if their MAGI exceeds certain thresholds. In 2021, this threshold is $140,000 for single filers and $208,000 for married filers. If your income is approaching these thresholds, talk to your IRA custodian about your concerns before moving forward with the recharacterization.
- Ask your IRA custodian for help. Recharacterizations can get complicated. For example, when you recharacterize only a portion of your IRA balance, the earnings and losses associated with that recharacterization must also be transferred. Fortunately, your custodian will perform this calculation for you.
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