If You Forgot to Claim Your IRA Deduction
Know Your IRA Deduction Options
The tax code is complicated, particularly after all the rules that fell into place in 2018. It's easy to forget or overlook something, but the opportunity isn't gone forever if you neglect to take certain tax deductions. You can still claim deductions for annual contributions you made to your traditional individual retirement account (IRA) in previous years.
You can fix this situation in a couple of ways, depending on how you want your retirement money to be taxed.
You have two choices when it comes to IRAs. Your contributions can be either tax deductible or nondeductible.
You can claim a deduction at tax time for the money you put in, which is what most people do. These contributions reduce your taxable income in the year you make them, then they grow tax-deferred until you retire.
The withdrawals are included in your taxable income when you begin withdrawing money from your IRA in retirement because they weren't taxed the first time around—you claimed those deductions for your contributions.
People who expect to be in a lower tax bracket during their retirement years should typically make deductible IRA contributions and take the tax break before retirement.
You can also make nondeductible contributions to a traditional IRA. These contributions don't reduce your income for tax purposes, but they'll grow tax-deferred until your retirement. Contributions that you don't claim a deduction for come back to you tax-free when you begin withdrawing the money.
Roth IRAs vs. Nondeductible IRAs
Many people prefer to contribute to Roth IRAs rather than make nondeductible contributions to traditional IRAs. Contributions aren't tax-deductible with a Roth IRA, either, and they also grow tax-free until you retire. The withdrawals are completely tax-free—even the accrued interest and growth—when you begin withdrawing money from a Roth IRA, as long as you've met all the requirements.
You must have held the account for at least five years, and be age 59½ or older as of the date of the withdrawal. Exceptions exist if you're disabled, a first-time homebuyer, or for your beneficiaries after you die.
People generally prefer to make Roth IRA contributions if they expect to be in approximately the same tax bracket or a higher tax bracket when they retire.
The Decision You Must Make
You must decide how you want your IRA to be taxed if you forgot to claim your IRA deductions in previous years.
You can take the tax deduction now, get some extra tax refund money, then have this income taxed later on when you retire and make withdrawals. Or you can forget about the tax deduction now and take the money tax-free later.
A tax professional can help you figure out which option is best for your personal circumstances, and you'll want to consult with a professional to make sure you have a full understanding of all the results of your choice.
What If You Do Nothing?
The IRS will treat your contributions as though they were deductible if you don't make a decision. The funds will be taxable when you withdraw the money in retirement because they were deductible when you contributed them. You can avoid that by taking an additional step.
If You Want the Deduction Now
File amended tax returns for any years that are still open for amendment under the IRS statute of limitations. This is usually three years from the date you filed the return, or two years from the date when you last made a payment on the return, whichever is later.
Claim the tax deductions for the IRA contributions on your amended returns. You might 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 could pass the statute of limitations and the IRS won't send you a check.
If You Want Tax-Free Withdrawals
File IRS Form 8606 to declare your IRA contributions as nondeductible if you want tax-free withdrawals. You must 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 might be partially taxable or completely tax-free, depending on how much your initial investments have grown.
Converting to a Roth IRA
Follow the same procedure, filing Form 8606 for each year, if you made contributions more than three years ago.
You can't get additional refunds from the IRS for tax returns that are more than three years old, so you'll gain no tax benefit by claiming a deduction for those IRA contributions at this point. Just file Form 8606 to establish that these contributions are nondeductible so you're free to convert the funds to a Roth IRA.
Will Form 8606 Late Risk an Audit?
Jesse Weller, a spokesperson for the IRS, indicates that:
"Although Form 8606 is normally submitted with a timely-filed Form 1040, the IRS will process a late-filed Form 8606, even one that's 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 if that form isn't 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 be appropriate for taxpayers who made nondeductible traditional IRA contributions. Filing the form establishes your basis in the IRA, and it will help prove that income tax should not be paid on those contributions when distributions are received.
At a minimum, taxpayers who fail or forget to file form 8606 should expect to receive an inquiry from the IRS, asking them to explain and verify their nondeductible contributions. Avoiding such an inquiry—or an audit—is a good reason to file the form.
It's possible that you could be charged a $50 penalty under the terms of Internal Revenue Code section 6693(b)(2) for failing to file a Form 8606 unless the failure is due to reasonable cause.
Note: Tax laws change frequently and the above information might 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.
IRS. "Roth IRAs." Accessed Jan. 8, 2021.
IRS. "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)." Accessed Jan. 8, 2021.
IRS. "Amended Returns and Form 1040X." Accessed Jan. 8, 2021.
IRS. "2020 Instructions for Form 8606." Page 6. Accessed Jan. 8, 2021.