What is a Nondeductible Contribution?

Mary McMahon
Mary McMahon

A nondeductible contribution is a deposit in a retirement account that is not considered tax deductible. People can voluntarily decide to pay taxes on their contributions, but more commonly, nondeductible contributions happen when people have exceeded the tax-exempt limit for the year and wish to deposit more in their retirement accounts. When people start to withdraw their contributions, the taxes can get extremely complicated if they have blended deductible and nondeductible contributions. This is an important consideration to think about when planning for retirement.

Man climbing a rope
Man climbing a rope

People saving money in retirement accounts are provided with an incentive in the form of a tax exemption on funds deposited for retirement. The government limits the amount of income people can exempt from taxation each year with this tactic, with limits varying from year to year and on the basis of marital status and income. While people are welcome to save more than the government limit each year, the excess funds will be subject to income taxes and any deposit over the limit is considered a nondeductible contribution.

Employees taking advantage of a savings plan sponsored by an employer can run into the nondeductible contribution problem when retirement benefits are paid by the company and the employee chooses to make additional deposits. Likewise, people with very high income aren't offered tax incentives for saving and they will end up with contributions they need to pay taxes on. Each nondeductible contribution must be accounted for so the employee can pay taxes on it.

People facing this problem may wonder if making a nondeductible contribution is worth it, since they are not receiving tax benefits on their income. The tradeoff is that any income earned in the retirement account is not taxed until people draw on it. Furthermore, people are not penalized with capital gains taxes when they change a retirement portfolio, as they are simply moving investments, not using the funds. Thus, people making nondeductible contributions do experience tax savings in the long term, as they don't need to pay taxes on interest income associated with their retirement accounts as the interest accrues. Some people find this enough of an incentive to open a nondeductible account or to mix deductible and nondeductible contributions in a single retirement account.

An accountant can provide more information about retirement savings options for people who are concerned about paying for retirement. People who decide to made nondeductible contributions should keep very good records covering their financial activities in retirement accounts. Planning ahead when it comes to organizing retirement accounts can help reduce confusion and added work later and people who have not done this may want to talk to a financial planner.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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