Forgot to Claim IRA Deduction

Options If You Forgot to Claim Your IRA Deduction

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"J.F." in California forgot to claim his IRA deduction:

"This year I took my taxes to a tax professional. The accountant reviewed copies of my earlier tax returns. It turns out I never took a tax deduction for contributions I made to a traditional IRA account. What can I do now?"

There are a couple of things J.F. can do depending on how he wants his retirement money taxed. You have two basic options if you find yourself in this predicament.

 

Some IRA Basics

You can have two types of traditional individual retirement accounts or IRAs: 

  • You can make tax-deductible contributions, which is what most people do. These contributions reduce your taxable income in the year you make them. They then grow tax-deferred until you retire. When you begin withdrawing money from the IRA, the withdrawals are included in your taxable income. People who expect to be in a lower tax bracket during their retirement should typically be making deductible IRA contributions.
  • You can also make non-deductible contributions to a traditional IRA. These contributions do not reduce your income for tax purposes, but they still grow tax-deferred until your retirement. When you begin withdrawing money, the non-deducted contributions come back to you tax-free.

    Many people prefer to contribute to a Roth IRA instead of to a non-deductible IRA. Contributions are not tax-deductible with a Roth IRA. They grow tax-free until you retire. When you begin withdrawing money from a Roth IRA, the withdrawals are completely tax-free -- even the accrued interest and growth -- as long as you've met all the requirements.

    People generally prefer to make Roth IRA contributions if they expect to be in approximately the same tax bracket or higher when they retire.

    The Decision You Must Make Now 

    If you forgot to claim your IRA deduction, the first thing you must decide is how you want your IRA to be taxed. Do you want to take the tax deduction now, get some extra tax refund money, then have this income taxed later when you retire? Or would you rather forget about the extra tax deduction and just let this money grow tax-free? Your tax professional can help you figure out which option is best for you.

    What If You Do Nothing? 

    If you don't make a decision, the IRS will treat your contributions as though they were deductible. When you withdraw the money in retirement, the funds will be taxed again. You'll end up paying tax twice on the same income. I'm pretty sure you don't want that, so here's what to do step by step:

    • If you want a tax deduction now (Deductible IRA): File amended tax returns for any tax returns still open under the statute of limitations. That's usually the three previous years. Claim the tax deductions for the IRA contributions on the amended returns. You'll probably receive some extra tax refunds for each of these years. File your amended returns by the current year's tax due date or your refund will pass the statute of limitations and the IRS won't send you a check.
    • If you want tax-free withdrawals (Roth IRA): File IRS Form 8606 to declare those IRA contributions as non-deductible. You'll have to file a Form 8606 for each year that you made contributions to your traditional IRA but forgot to take the deduction. Then instruct your investment broker to convert your traditional IRA to a Roth IRA. The conversion may be partially taxable or completely tax-free, depending on how much your initial investments have grown.
    • If you made contributions more than three years ago: Follow the same procedure for filing Form 8606 for each year. For tax returns over three years old, you cannot get additional refunds from the IRS, so you'll gain no tax benefit by claiming a deduction for IRA contributions. Just file Form 8606 to establish that these contributions are non-deductible, then you're free to convert the funds to a Roth IRA.

      Will Filing Form 8606 Late Raise Red Flags With the IRS? 

      I asked the IRS and here's what I was told. According to Jesse Weller, a spokesperson for the IRS:

      "Although Form 8606 is normally submitted with a timely-filed Form 1040, the IRS will process a late-filed Form 8606, even one that is filed after the normal three-year statute of limitations for claiming a refund has expired. The Form 8606 can be submitted without a Form 1040 or Form 1040X (amended return) if those forms are not otherwise required. If the form is filed by itself, it should be signed on page two right below the jurat (the written declaration that verifies that a return, declaration, statement or other document is made under penalties of perjury). 

      This would definitely be appropriate for taxpayers who made a nondeductible traditional IRA contribution. Filing the form establishes their basis in the IRA, and it will help prove that income tax should not be paid on that contribution when distributions are received. Taxpayers failing to file the form should, at a minimum, expect to receive an inquiry by the IRS asking to explain and verify the nondeductible contributions, so avoiding such an inquiry -- or an audit -- is a good reason to file the form.

      Taxpayers should be aware that under IRC section 6693(b)(2), they may be charged a $50 penalty for failing to file a Form 8606 (unless the failure is due to reasonable cause) so that is another good reason to file the form."

      Bottom line
      If you forgot to claim your IRA deduction, File Form 8606 to establish that the contributions were non-deductible, then convert your funds to a tax-free Roth IRA. For returns filed in the last three years, you can choose whether to take the deduction and get a refund, or declare the contributions as non-deductible.

      NOTE: Tax laws change frequently and the above information may not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice, and it is not a substitute for tax advice.

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