Deductible Vs. Nondeductable IRAs

Mark Kennan, Demand Media writes: Individual retirement accounts aren't called "deductible IRAs" or "nondeductible IRAs." Instead, deductible or nondeductible refers to how your contributions are treated on your taxes. How those contributions affect the taxes on your withdrawals depends on whether you're taking them out of a traditional IRA or a Roth IRA.

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TRADITIONAL IRAS

Traditional IRAs accept both deductible and nondeductible contributions. If you or your spouse is covered by an employer-sponsored retirement plan and your modified adjusted gross income exceeds the annual limits, you're limited to making nondeductible traditional IRA contributions. If you're not covered, or you are but your income isn't too high, you have the option of making nondeductible contributions if for some reason you don't want to deduct your contribution on your tax return for the year that you make it.

DISTRIBUTIONS FROM TRADITIONAL IRAS

If your traditional IRA contains nondeductible contributions, slightly different rules apply to your withdrawals. No matter when you take the money out, each distribution is prorated between your nondeductible contributions and the rest of your account because the nondeductible contributions portion comes out tax free. For example, say you have $50,000 of nondeductible contributions and your traditional IRA is worth $200,000 -- 25 percent of your account is nondeductible contributions. If you take out $10,000, $7,500 is taxable and $2,500 isn't. Your account now only has $47,500 of nondeductible contributions in it.

ROTH IRAS

Roth IRA contributions are always nondeductible, no matter your financial circumstances or participation in an employer plan. That's because Roth IRAs are after-tax savings accounts and offer tax-free distributions on qualified withdrawals. To take qualified withdrawals, you have to wait at least five years after the start of the first tax year you made a contribution. Also, you must be either at least age 59 1/2, permanently disabled or taking out up to $10,000 for a first house. Failing to meet one of the criteria means you're taking an early withdrawal.

EARLY ROTH IRA WITHDRAWALS

Early withdrawals from Roth IRAs are less painful because of the distribution ordering rules. Instead of prorating your distribution, you're allowed to take out all your contributions -- tax-free and penalty-free -- whenever you want. After you've depleted your contributions, only then do you tap your earnings, which are taxed and penalized on early withdrawals. For example, say your Roth IRA has $50,000 of contributions in it. Any distribution up to $50,000 comes out tax free.