What are the tax implications for a traditional IRA when your AGI is above the threshold that allows any deductions on contributions?
As you mention, even though everyone with earned income (or a working spouse) can contribute to a Traditional IRA, some taxpayers may not be able to deduct the contribution. It appears you fall into that category! Sorry you can't get the deduction but congratulations on having a great income!
All is not lost, though. You can track your non-deductible contributions to your Traditional IRA on IRS Form 8606. When you later take withdrawals from your IRA, you can reduce the taxable income you claim by a prorated share of your nondeductible contributions. This is best illustrated by example. Assume you contribute $5,000 to a Traditional IRA and are unable to deduct the contribution. Years later, the IRA has grown to $20,000 (with no additional contributions). The non-deductible contribution percentage of the IRA balance is 25% ($5,000/$20,000), therefore, when you withdraw, for example, $8,000 from the IRA, you will only pay tax on $6,000 as the other $2,000 represents a return of your non-deducted contribution.
If you have no other IRA's when you make the non-deductible contribution, you could then do a Roth conversion with little to no tax due. It won't allow you to deduct the contribution this year, but at least the funds will grow tax-free into the future (assuming you follow the Roth IRA rules, of course).
Thanks for your question!
Thank you for asking this question. If you or your spouse are not covered by a employer retirement plan (Such as a 401K plan) then you can contribute $5500 per year (and so can your spouse or you can contribute for your spouse if he/she has no income) to a traditional IRA as long as you have earned income (ie income from wages, tips etc). The contributions go up to $6500 per year if you are over 50 years. The entire amount is tax deductible ie you will contribute with pretax money.
If you or your spouse are covered by a retirement plan at work, then the amount that can be deducted is reduced depending on your AGI. You can however contribute after tax amounts up to the limits ($5,500/$6,500).
Here are the tables in the IRS website explaining the above: https://irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-not-covered-by-a-retirement-plan-at-work
If you contribute before taxes, then it grows tax deferred ie you do not pay any taxes until you withdraw. When you withdraw you pay ordinary income taxes on the entire contribution. (There will be a penalty of 10% if you are under the age of 59.5 years). If you contribute after tax then only earnings will be taxed at the ordinary income tax rate as above.
As disappointing as it is not being eligible to claim a tax deduction on your IRA contribution, I'd say it is a pretty good problem to have! Based off your question, I will assume you or your spouse is covered by some type of qualified retirement plan (457 plans won't subject you to phaseout) with your employer that phases out your deductibility. If neither of you were covered by a plan at work then your contribution would be deductible regardless of income. However, the good news is that you will not be taxed twice on the contributions to your IRA so long as you keep track of your non-deductible contributions on IRS Form 8606. By keeping track of your non-deductible contributions on Form 8606, you will know what amount of your IRA is made up of non-deductible contributions and what amount is made up of gains. A simple example would be if you made $10,000 of non-deductible contributions but the IRA balance was $30,000 when it came time to withdraw funds. The $10,000 contribution makes up 1/3 of the $30,000 account balance. So, if you were to withdraw $15,000, 1/3 ($5,000) of that would be a return of principal (tax-free) and the other 2/3 ($10,000) would be taxable at your marginal tax rate. That is the rundown on taxation of non-deductible contributions at withdrawal. However, I would also suggest looking into a Roth conversion strategy to convert non-deductible IRA contributions into Roth money that can grow without tax consequences at qualified withdrawal. Lastly, if your cash flow allows it and you aren't already maxing out your qualified plan (401k, 403b, etc.) deferrals, I would strongly suggest it! I hope this helps!
So if you make a contribution to a Traditional IRA and are over the income limit you simply won't receive any deduction for the contribution. Then what will happen is in the future when you pull the principal out you will also pay no taxes. The big caveat here is that the growth if you leave it in the Traditional IRA when pulled out will be taxes at ordinary income. Low and behold the strategy of doing a back door roth. The smarter approach is make that contribution and then you can convert the after tax dollars to a Roth IRA the very next day. Then the dollars will grow tax free in the Roth and you'll pay no taxes on the conversion. Just be careful that if you have any other IRA's (not 401(k)'s) that are pretax the conversion will proportionally account for pre-tax dollars. If you have no Traditional IRA's then you don't have to worry. Hope that helps.