If you make nondeductible contributions to a traditional IRA, you must file a Form 8606 with your return. This is important because it will keep you from overpaying your taxes when you withdraw funds from your IRA. Any money that you don't get to deduct when it goes into your IRA is tax-free when it comes out. The Form 8606 is the way to keep track of your "basis" in the account.
If you are covered by a retirement plan at work and your adjusted gross income in 2006 is over $50,000 on a single return or over $75,000 on a joint return, your right to deduct up to $5,000 in IRA contributions is in jeopardy. The deduction is phased out as AGI rises $10,000 above those thresholds. A single person with $55,000 AGI is allowed to deduct no more than $2,000, for example, because $55,000 is midway between the $50,000 threshold and $60,000, where the deduction is wiped out completely. These are the phase-out zones for 2006.
Whether or not you can deduct your contributions, you can still deposit up to $4,000 a year into a traditional IRA. The limit is $5,000 for those age 50 and older. (These are the limits for 2006 — and you can make 2006 contributions as late as April 17 of 2007. In 2007, the basic contribution level will remain at $4,000, with the extra "catch up" contribution for those age 50 and older remaining at $1,000) However, there is no reason to make a nondeductible contribution to a traditional IRA if you qualify to make a nondeductible contribution to a Roth IRA. Neither produces immediate tax-savings but there's a big difference down the road. When earnings are withdrawn from a traditional IRA, they are sure to be taxed in your top bracket; when earnings are withdrawn from a Roth, they are absolutely tax-free, assuming certain conditions are met. Thus, the only taxpayers for whom nondeductible contributions to a traditional IRA make sense are those whose income is too high to qualify for a Roth IRA. (The right to contribute to a Roth IRA evaporates as adjusted gross income rises from $90,000 to $110,000 on an individual return and from $150,000 to $160,000 on a joint return.)
Here's a review of the basic rules for traditional IRAs:
The IRA is open to anyone under age 70 1/2 who receives compensation, which is earnings from a job rather than income from investments. Income that counts for IRA purposes includes:
Income that doesn't count as compensation includes:
For 2006, the annual limit on IRA contributions is $4,000 or 100% of your compensation, whichever is less. (The dollar limit is $5,000 for taxpayers age 50 and older.) Thus, if you earn just $1,000, your maximum IRA contribution for the year is $1,000. Investments inside the IRA grow tax-deferred. In 2007, the basic limit remains $4,000 with the extra "catch up" contribution for those age 50 and older staying at $1,000.
There is no minimum age for IRA participation. If your 10-year-old has compensation—from a paper route, say, or from working in a family business—he or she can stash up to $4,000 of that pay in an IRA in 2006 and another $4,000 in 2007. (The extended period of time such a contribution would have to grow inside an IRA accentuates the power of this tax shelter. A single, $4,000 investment at age 10 would grow to $275,000 by age 65, assuming an average 8% annual return and more than $750,000 assuming a 10% annual return.)
Starting with the year you reach age 70 1/2, you can no longer make contributions to a regular IRA. (That's also the age that triggers the requirement that you begin withdrawing funds from your IRA.) For taxpayers born between July 1, 1936, and June 30, 1937, for example, 2006 is the final year for traditional IRA contributions.
The Roth IRA is similar in some respects — the need for compensation, for example, and the $4,000 annual contribution limit for 2006 ($5,000 for those age 50 and older) and the same limits for 2007. If you use both a traditional and a Roth IRA, the annual ceiling applies to the total you put into the accounts. But it is dramatically different in most other ways:
If you have been contributing to a nondeductible IRA, consider converting it to a Roth IRA. You do have to pay tax on any earnings that have accumulated in the IRA, but there would be no tax on your nondeductible contributions. The advantage of the conversion: All earnings from that point forward inside the Roth IRA will be tax-free, not just tax-deferred.
There is an exception to the $4,000/$5,000 annual 2006 limit for couples in which one spouse does not have a job. In addition to your own traditional or Roth IRA, you can open a regular or Roth IRA for a nonworking spouse and contribute a total of $8,000 to the two accounts for 2006 ($10,000 if husband and wife are both age 50 or older). Also, you may continue contributing up to a nonworking spouse's traditional IRA even after you reach age 70 1/2, assuming he or she is under that age.
When the spousal IRA rules were originally written, when one spouse was covered by a company retirement plan, both husband and wife were considered covered for purposes of the regular IRA deduction phase-out. Now, however, a spouse who was not covered by a company plan can deduct contributions to a traditional IRA as long as the couple's adjusted gross income is under $150,000. The right to the deduction is phased out as income rises to $160,000.
The government is serious about the annual limits. Excess contributions are hit with a 6% penalty tax. Assume, for example, that you work part-time in 2006 and, expecting to earn more than $4,000 for the year, you deposit $4,000 in your IRA at the beginning of the year. Because you have a bad year, though, your earnings total just $1,500. Your deduction is limited to $1,500, and the extra $2,500 is considered an excess contribution subject to the 6% penalty. That will cost you $150.
The penalty applies each year until the excess is either withdrawn or absorbed by the unused portion of a future year's contribution. If you qualify for a $4,000 contribution the following year, for example, depositing just $1,500 would absorb the $2,500 excess contribution and avoid another 6% penalty. You'd get to deduct the extra $1,500 in the second year.
It's possible to dodge the first-year penalty, too, by withdrawing the extra money before you file your tax return for the year involved. Because you had not yet deducted the IRA deposit, you don't have to report the withdrawal as income. Any earnings on the extra $2,500 should be withdrawn from the account, too. That amount would be taxed, and if you are under age 59 1/2 at the time, the earnings would also be hit with a 10% early-withdrawal penalty.