If You Forgot to Claim Your IRA Deduction

Know Your IRA Deduction Options

Elderly woman looking frustrated while reviewing financial documents with a laptop
••• PeopleImages / Getty Images

It happens. You're a busy person, and it's difficult to carve out numerous hours in your schedule to prepare your tax return. Add to that the fact that the tax code is pretty complicated and can be overwhelming for the average taxpayer. It's incredibly easy to forget or overlook something when you're feeling pressured and lost.

So what if you throw in the towel this year and decide to let someone else deal with it? Forget the pen and paper or the sometimes confusing tax software. You're going to turn it all over to a tax professional instead. Then the tax professional looks at copies of your tax returns for previous years and points out that you never took deductions for the annual contributions you made to your traditional IRA account.

Is the opportunity gone forever? No. You can do a couple of things to fix the situation, depending on how you want your retirement money taxed.

Deductible Versus Non-Deductible Contributions

You have two choices when it comes to traditional individual retirement accounts or IRAs. You can make tax-deductible contributions, which is what most people do—they claim a deduction at tax time for the money they put in. These contributions reduce your taxable income in the year you make them, then they grow tax-deferred until you retire.

When you begin withdrawing money from your IRA, the withdrawals are included in your taxable income because they weren't taxed the first time around—you claimed those deductions for them. 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 and when you begin withdrawing money, the non-deducted contributions come back to you tax-free.

Roth IRAs Versus Non-Deductible IRAs

Many people prefer to contribute to a Roth IRA rather than make non-deductible contributions to a traditional IRA. Contributions are not tax deductible with a Roth IRA, either, and they also 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 a higher tax bracket when they retire.

The Decision You Must Make Now 

If you forgot to claim your IRA deductions in previous years, 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 on when you retire? Or would you rather forget about the tax deduction now and take the money tax-free later?

Your 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? 

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 a second time. 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: File amended tax returns for any tax returns that are still open under the IRS statute of limitations, which is usually the three previous years. Claim the tax deductions for the IRA contributions on your 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: File IRS Form 8606 to declare those IRA contributions as non-deductible. You'll have to file 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. 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 IRA contributions at this point. Just file Form 8606 to establish that these contributions are non-deductible, and then you're free to convert the funds to a Roth IRA.

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

Here's what Jesse Weller, a spokesperson for the IRS, has to say about it:

"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 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 that contribution when distributions are received. At a minimum, taxpayers who fail or forget to file form 8606 should expect to receive an inquiry by the IRS asking to explain and verify the non-deductible contributions. Avoiding such an inquiry—or an audit—is a good reason to file the form.

The Bottom Line 

It's possible that you might 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. That's another good reason to file the form.

After you've filed Form 8606 to establish that the contributions you made were non-deductible, you can 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.

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.