In order to make an IRA contribution, you must be younger than age 70 1/2 for the year and also have wages or compensation from your job. Once you make your IRA contribution, then you have to figure out whether it's tax deductible or not.
If you make an IRA contribution that isn’t tax deductible, you must file IRS Form 8606 to report it as nondeductible. You will now have what’s known as “basis” in your IRA (money that isn’t taxable when you later take a withdrawal). Even though you may not get a tax deduction, nondeductible IRA contributions will give you tax-deferred interest just like all of your other IRA money; plus, you are saving more money for your retirement.
When you have basis, you’ll also have to file Form 8606 in any year you take a distribution from any traditional IRA, including SEP and SIMPLE IRAs, to calculate the nontaxable portion of your withdrawal.
If you don’t file Form 8606 to report nondeductible contributions, then there’s a $50 IRS penalty. But worse than that, if you can’t prove you have basis, all of your future IRA distributions will be treated as fully taxable.
Roth IRA contributions are also not tax deductible, but you don’t file Form 8606 to report Roth contributions. If you discover that your IRA contribution isn’t tax deductible, you are better off making a Roth IRA contribution instead. Assuming your income isn’t too high, the Roth IRA funds grow tax-free, not just tax-deferred. The income limits for making a Roth IRA contribution for 2013 are $178,000- $188,000 if you’re married filing jointly or $112,000 - $127,000 if you’re single.
For example, if you’re married filing joint and you and your spouses’ total income is below $178,000, you can make a full Roth IRA contribution of $5,500 (or $6,500 if you’re age 50 or older).
-By Joe Cicchinelli and Jared Trexler