There is No Such Thing as a Non-Deductible IRA

Friday, October 05, 2012

I hear this a lot. “The contribution is to a non-deductible IRA.” Or, “I have a non-deductible IRA.” There is no such thing as a non-deductible IRA. There are non-deductible contributions made to an IRA.

Think about it. Even if a contribution is made to a non-deductible IRA, it will not remain entirely non-deductible for long. There are some sort of earnings on the account – even if it is invested in a money market IRA. Would you make a contribution to an IRA that guaranteed no earnings for as long as you had any funds in the account?

Here are some other reasons why there is no such thing as a non-deductible IRA.

  • The IRA custodian is not responsible for tracking your non-deductible dollars in an IRA. You do that by filing Form 8606 with your tax return.
  • For tax purposes, all IRAs (except for Roth IRAs) are considered one IRA and your distributions are taxed pro-rata – partly from your deductible (pre-tax) IRA funds and partly from your non-deductible (after-tax) IRA funds.

Once you have both deductible and non-deductible amounts in any IRA that you own, including SEP and SIMPLE IRAs, you generally can never take out only the non-deductible amounts. We call this the cream in the coffee rule. Once you put cream in the coffee, all coffee removed from the cup is partly cream and partly coffee.

The taxability of any distribution from any IRA once you have made a non-deductible contribution is calculated on that same Form 8606. An IRA owner must file this form in any year that they make a non-deductible contribution and in any year that they take any distribution from any IRA after they have non-deductible funds in any IRA.

Article Highlights

  • There is no such thing as a non-deductible IRA
  • When there is after-tax money (basis) in any IRA, the pro-rata rule applies to all IRA distributions
  • After-tax funds are tracked on IRS Form 8606, which the taxpayer files with their tax return 

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