Updated for 2024 – 2025. Investors often ask: should I be making nondeductible IRA contributions? In the vast majority of cases the answer is no. Why non-deductible? Because many taxpayers earn too much to make pre-tax IRA contributions as they have a 401(k) at work.
Although any investor with earned income can make a non-deductible contribution to an IRA (up to $7,000 in 2024-2025 if under age 50) and still take advantage of tax-deferred growth, it still may not be advisable. Many people end up paying taxes twice.
IRA funding rules: nondeductible versus deductible
Excluding a rollover from a retirement account, there are two ways you can save money in a traditional IRA annually (assuming you have earned income):
- Deductible (pre-tax) which grows tax-deferred and withdrawals are taxed as regular income
- Nondeductible (after tax dollars) which also grows tax-deferred and investment growth is taxed when withdrawn (but more on this later). Note that non-deductible IRAs differ from money in a Roth IRA where withdrawals are tax-free provided the requirements are met
Regardless of the type of contribution above, the overall funding limit is the lesser of: $7,000 in 2024 and 2025, $8,000 (if age 50+), or your earned income.
Who can make deductible IRA contributions?
There are income limits for contributions to a traditional IRA that qualify for a tax deduction.
- The deductibility phase-out is based on filing status, income (MAGI), and whether or not the individual(s) are eligible to participate in a retirement plan at work. See 2024 limits and 2025 limits
- The amount that qualifies as a deductible contribution may be capped depending on your income
Can I make a nondeductible contribution to an IRA?
- As long as you have earned income, you’re eligible to make a non-deductible IRA contribution subject to the overall funding limits above
Should I make non-deductible IRA contributions?
Here are five reasons we suggest skipping nondeductible IRA contributions:
- How non-deductible contributions are taxed
- Never-ending recordkeeping requirements
- Capital gains tax rates vs ordinary income
- State tax rules, inherited IRA issues, and RMDs
- Other accounts may be better retirement planning vehicles
1. How non-deductible IRA contributions are taxed when withdrawn
Are non-deductible IRA contributions taxed? Yes and no. When you make a distribution, the original nondeductible IRA contribution amount isn’t included in your taxable income, but the earnings and growth from it is.
However, if you’ve made deductible and non-deductible IRA contributions, you can’t choose to just withdraw the after-tax portion. Each time you take money out from individual retirement accounts, you won’t need to pay taxes on the proportion of nondeductible contributions to all IRA assets. This is called the pro-rata rule.
Pro-rata rule
The IRS pro-rata rule applies to withdrawals from a traditional, SEP, or SIMPLE IRAs with tax deductible and after tax (non-deductible, non-Roth) funds. It doesn’t matter which account the contributions are in or how many accounts you have.
So if you have deductible and non-deductible IRA contributions, you’ll use the pro-rata rule, and a percentage of every distribution will be tax-free with the remaining portion fully taxable.
To calculate the tax-free percentage:
Your Total Basis (e.g. lifetime non-deductible contributions – previous nontaxable distributions) divided by Total IRA Assets (e.g. balance in all IRAs (except Roth) as of 12/31 + all distributions in the current year + outstanding rollovers)
To find the tax-free dollar amount, multiply the tax-free percentage by the full amount of IRA distributions throughout the year.
Simple example of how income taxes work using the pro-rata rule
Assume you are age 60 and plan to begin taking distributions from your IRA account. Over the years you made $100,000 in nondeductible IRA contributions. Your traditional IRA was worth $1,000,000 on 12/31 of the prior year.
Tax-free portion of every dollar you withdraw that tax year = $100,000 / $1,000,000 = 10%.
2. Tax reporting when making non-deductible IRA contributions
One of the most misunderstood aspects of making non-deductible IRA contributions is the recordkeeping process. The IRS requires the taxpayer to track and report non-deductible contributions. This is a key reason why non-deductible contributions aren’t typically worthwhile as the taxpayer often ends up paying tax twice.
You must tell the IRS you’ve already paid tax on those additions using Form 8606. If you don’t report, track, and file the form, when you take the money out, you’ll pay federal income tax on the same dollar twice.
To prove that you’ve already paid tax on nondeductible contributions, you must keep the documentation forever. The IRS doesn’t track your after-tax basis, even when you file the right tax forms.
Once you make non-deductible contributions, you’ll use the same form to take a distribution or make a Roth conversion. The form is necessary as you’ll need to calculate the non-taxable portion of the withdrawal or conversion. The form itself is not especially complex, particularly if you’re working with a CPA. But it can create issues over a long period of time.
What if you’ve previously made non-deductible contributions and forgot to file Form 8606? The good news is this can be an easy problem to fix. From a tax reporting standpoint, you can simply file Form 8606 with your next tax return to reflect historical non-deductible IRA contributions.
3. Capital gains tax rates versus regular income
The only reason to consider making an after-tax contribution to a traditional IRA is tax-deferred growth. If you had invested in a taxable brokerage account instead, you’d have to pay tax on interest, dividends, and capital gains distributions annually, even if you don’t sell any shares.
While you avoid paying tax annually on earnings and growth on after-tax contributions, when you take distributions in retirement, a portion is taxed as ordinary income. In 2024 and 2025, the highest marginal tax rate is 37%.
However, in a brokerage account, only short-term capital gains and non-qualified dividends are taxed at the higher regular income tax rates. Long-term capital gains and qualified dividends taxed at much lower rates. In 2024 and 2025, the rate is between 0% and 20% depending on your regular income bracket. (An additional 3.8% federal net investment income tax may apply to certain taxpayers).
Investors should consider whether the additional years of deferred growth are worth a tax rate that could be double down the road.
4. State tax, inherited IRAs, RMDs
State tax laws
The focus of this article is on the federal income tax, but it’s important to remember some states have their own rules. Massachusetts, for example, does not follow the federal rules on tax deductible contributions or recovering ‘basis’ on distributions. In the Commonwealth, all IRA contributions are considered after-tax. So your tax basis will be different federally and in Massachusetts when you begin withdrawals, if you haven’t moved. The taxpayer and their CPA must track this.
Tracking for inherited IRAs
Your beneficiaries not only must know you’ve made non-deductible IRA contributions, they also need the records to prove it. Otherwise, the money will be taxed twice.
Required minimum distributions
When you make nondeductible contributions to an IRA, a certain percentage of your RMD is tax-free. However, if you made after-tax and pre-tax contributions, your overall pool of assets subject to RMDs increases. Particularly for wealthy retirees, annual RMDs often exceed cash needs. This can push individuals into a higher marginal tax bracket and cause other tax-related issues, like higher Medicare premiums.
Comparing Investment Options After Maxing Out a 401(k): Brokerage vs. IRA vs. Roth IRA
5. Other account options
Taxable brokerage account
As explained above, a taxable brokerage account is a completely flexible way to invest for any goal. There are no contribution limits, withdrawal rules, mandatory distributions…or tax benefits (except at death – called the step-up in basis). There’s also no forever recordkeeping requirements or penalties if you need the money before retirement.
Roth IRA or Roth 401(k)
A Roth IRA is funded with after-tax dollars, just like a non-deducible contribution. But not everyone can contribute, so if your income is too high to make a regular Roth IRA contribution, this won’t be an option. See 2024 limits and 2025 limits. There are no income limits for Roth 401(k) contributions, but again, consider your expected future tax rate, current tax situation, and need for liquidity before age 59 1/2.
Roth conversion
With a Roth conversion, pre-tax IRA funds are taxed, which converts the money into after-tax Roth dollars. Again, the pro rata rule applies, so it’s often best to consider a Roth conversion when rolling over an old 401(k). There are no income limits on Roth conversions.
Backdoor and mega backdoor Roth
In a backdoor Roth, investors make a non-deductible contribution to a traditional IRA and then quickly convert to a Roth IRA. Once the money is in a Roth IRA, it’s tax-free when taken out (if you meet the holding period and age requirements). This strategy only works if you don’t have any other traditional IRAs. Otherwise, the pro rata rule applies.
In a mega backdoor Roth, you max out individual additions to your 401(k) then make after-tax (non-Roth) contributions up to the annual maximum (combined employee and employer). You then elect an in-plan Roth 401(k) rollover or roll the after-tax contributions into a Roth IRA.
Not all employer plans allow this and there are other considerations to keep in mind before implementing this or any of the other strategies in this article.
Should you make nondeductible IRA contributions?
Due to the ongoing recordkeeping and tax reporting requirements, pro rata rule, and other complexities, other investment options are usually more advantageous than the marginal tax benefit of after-tax IRA savings.
Keep in mind the relatively low contribution limit and other tax diversification options. Also consider the tax treatment of your whole pool of retirement savings. Taxes should be a factor, but not the driver, when making financial decisions. Consult your tax advisor and financial advisor to discuss your situation.
[Last reviewed November 2024]
