History

• Congress created Individual Retirement Accounts in 1974 as a way for people with no qualified company retirement plan to defer taxes on their retirement savings. Over the years, the IRA has evolved and expanded to allow almost anyone with earned income to contribute, but certain rules could limit your ability to take a tax deduction.
  
  

Nondeductible Contributions

• Your ability to take a full tax deduction for your IRA contribution begins to phase out as you pass certain income thresholds. Income thresholds are even lower for those covered by employer-sponsored retirement plans. However, because the IRS never taxes assets inside an IRA until they are withdrawn, you might choose to make a full contribution and take only a partial or no tax deduction in order to benefit from tax-deferred investment growth.
  
  

Basis Creation

• Your contribution to a traditional IRA (but not a Roth IRA) reduces your taxable income in the year you make your contribution. If you make the full contribution but you can't take the full tax deduction, you create a basis in your IRA consisting of the difference between the deductible and nondeductible amounts. For example, if you contribute $5,000 but you can only deduct $4,000, you establish a basis of $1,000 in your IRA for that year.
  
  

Reporting Nondeductible Contributions

• You must report your nondeductible contributions in order to avoid paying double income taxes on them. By reporting your nondeductible contributions each year on IRS Form 8606, you establish a record so that you can withdraw the nondeductible portion of your contributions tax free. Overlooking this step can be costly in another way: if you fail to file Form 8606 in the year you made your nondeductible contribution, the IRS could asses a $50 penalty.
  
  

Taxation of Distributions

• The IRS does not allow you to choose which portion of your contributions you can withdraw. Instead, you must follow a formula to determine how much of your distribution is from the deductible (or taxable) contributions you made. For example, say your accumulated basis in an IRA worth $100,000 at the end of the year is $10,000. You took a distribution in November of $10,000. To figure your tax, add your distribution to your year-end balance ($110,000) and divide by your basis ($10,000) to get a fraction (0.90909). Multiply your distribution by this fraction to get the tax-free amount of your distribution ($909.09). The remainder ($9,090.91) is taxable and should be added to your adjusted gross income at the end of the year.