Since 1987, individual investors who were not eligible to make deductible traditional IRA contributions have still been permitted to make non-deductible contributions. The original allure of this opportunity is/was that it gives people an additional avenue to save for retirement on a tax-deferred basis. While the popularity of non-deductible IRA contributions waned with the advent of Roth IRAs, it was commonly employed by consumers from the late 1980s through the 1990s, and is still used sporadically today by investors whose incomes are above the Roth IRA contribution eligibility limit
Although most taxpayers know that all IRA contributions (i.e., both deductible and non-deductible) must be reported on their tax returns, many are unaware that it is their responsibility to keep track of the amounts and years in which non-deductible contributions are made. Upon retirement, distributions from non-deductible IRAs are taxed on a pro-rata basis with the percentage of the distribution that may be attributable to the IRA holder’s after-tax contributions excluded from taxation. However, if the taxpayer is unable to substantiate the after-tax contribution amount and percentage, he/she/they may end up being taxed twice on the after-tax money!
Pro-Tip – Don’t Forget IRS Form 8606
Here’s a financial planning “Pro Tip” – If you are making a non-deductible IRA contribution, you should file IRS Form 8606 with your return. This form both documents the current year’s non-deductible IRA contribution and records the cumulative total of all prior year non-deductible IRA contributions. You will need this document when you eventually make your IRA distributions.
This same guidance applies to taxpayers who process annual “backdoor” Roth conversions. For the uninitiated, a backdoor Roth IRA conversion is a popular strategy for taxpayers whose incomes are too high for regular Roth IRA contributions and whose participation in company retirement plans precludes them from making deductible traditional IRA contributions. The 8606 filing requirement documenting the non-deductible IRA contribution still applies even when the conversion is made in the same year.
What if I forgot to file or was unaware of IRS Form 8606?
Last year, a fee-only client who told me that she had made deductible IRA contributions to a traditional IRA over the past 20 years that she had consolidated with a Rollover IRA. When I asked her what portion of the IRA money was attributable to after-tax contributions, I first got a blank stare. However, she had used a CPA. When I started going through her past returns I found that her CPA had filed 8606 in some year and not others and had failed to keep a cumulative total.
Fortunately, the IRS allows taxpayers to correct this mistake. Since my client had kept 20+ years of returns and since her non-deductible contributions were documented on each year’s returns, her new CPA filed new/cumulative forms for all prior years. We then helped her transfer the pre-tax portion of the IRA to her company 401(k) plan, which then enabled her to process a tax-free “backdoor” conversion of all of the non-deductible IRA contribution money to a new Roth Conversion IRA.
As you can see preparing late Form 8606 filings may require a bit of forensic bookkeeping, and readers are encouraged to enlist the expertise and assistance of a CPA, but the exercise may very well be worth the effort. In addition to avoiding double taxation, for some investors, careful planning may enable free Roth conversions of the non-deductible contribution amount.
This article is intended to raise awareness of an important tax planning issue. It also showcases the value of hiring a good fee-only financial planner.
Related Reading: –
What is a Backdoor Roth IRA Conversion (inDinero)
Forgot to File Form 8606 for Non-Deductible IRAs (About.com)
Late Form 8606 filings(Ed Slott and Company)
Sidestep Tax Hit by Reconstructing IRA Basis(On Wall Street)
Securities offered through J.W. Cole Financial, Inc. (JWC) member FINRA/SIPC. Advisory services offered through Financial Planning Hawaii and J.W. Cole Advisors, Inc. (JWCA). Financial Planning Hawaii and JWC/JWCA are unaffiliated entities.
Fee-only financial planning services are provided through Financial Planning Hawaii, Inc, a separate Registered Investment Advisory firm. Financial Planning Hawaii does not take custody of client assets nor do its advisers take discretionary authority over client accounts.
The information contained herein is general in nature. Neither Financial Planning Hawaii nor J.W. Cole provides client-specific tax or legal advice. All readers should consult with their tax and/or legal advisors for such guidance in advance of making investment or financial planning decisions with tax or legal implications.