Under what circumstances IRA contributions are not deductible even when they are within the yearly limits?

Question

Early in 2006 my spouse and I both contrinuted $5,000 each to IRA for tax year 2006. We are both over 50. On filling up the tax return for 2006, the tax program told us they the contributions are not deductible. What now? Will this be treated as excess contribution and subject to penalty? or we can let it sit there and not get the deduction? Can we recharacterize then as Roth contribution? Or can we just withdraw them without incurring penelty?

Answer 1

The contributions are not deductible because of income limits and either you, your spouse, or both have a retirement plan with your jobs and you both made too much money.

The amount will not be treated as an excess contribution, just as a non-deductable one which would need to be reported on Form 8606 which both you and your spouse will need to each file one with your tax return.

You have an option to recharacterize the contribution as a Roth IRA before the due date of your tax return (April 17, 2007 for most taxpayers) if your Adjust Gross Income (AGI) is below $150,000. You will need to inform the custodian of your IRS that you would like to rechariterize your contribution. There may be a fee for this service.

When communicating to the custodian make certain they understand that you want to rechariterize your 2006 contributions from the traditional IRA to a Roth IRA, they may confuse your request as a conversion to a Roth IRA which is a totally different thing.

Answer 2

You may have made an error with the tax program, or you may not qualify for a deductible IRA.

Are you over 70.5? Are you already a partipant in a retirement plan at work? Do you have income over the limits for a deductible IRA? You may want to ask a tax preparer to review your situation before doing anything more.

Anyone with compensation over $4k ($5k if over 50) under age 70.5 can contribute to a traditional IRA.

If you already contributed in addition to the $5k, then you have an excess contribution you need to take out ASAP or you will have an excise tax of 6% a year on that excess. Withdraw excess contributions and earnings by April 17.

If you qualify for a Roth IRA, you can recharacterize the traditional IRA as a Roth IRA. Your trustee can do this for you.

You also can withdraw your contribution and earnings by the due date of your return, including extensions, without penalty.

Details are all in Pub 590.

Answer 3

There is no penalty for making a nondeductible contribution; people do it all the time.

You might be able to recharacterize them as Roth, depending on your income. Or you can just leave them as they are, and file Form 8606 with your return. This notifies IRS that you have nondeductible contributions. When you retire and begin to draw out the money, that portion will be considered a tax-free return of basis.

Answer 4

More than likely your income was too high and you are already covered by a retirement plan through your work. It's not an excess contribution, but it isn't deductible either.