Retirement Income Toolbox

June 15, 2017


Most people when contributing to their various retirement savings vehicles are aware of the reporting requirements of deductible plans.  I recently read an article in April 2017’s by Tim Steffen that may open the eyes of some of the less known reporting requirements/suggestions when contributing to non-deductible plans.

At this point, nearly all taxpayers have completed the arduous task of compiling the information needed to prepare their 2016 tax returns, including sifting through receipts and statements to determine what’s needed for the return and what can be thrown out.  This is especially true for those who hire a CPA to prepare their tax return – they don’t want to pay to have them spend their time sifting through useless information.  In those cases, clients may be tempted not to include things they think won’t impact their returns, like, for example, the IRA contribution they know they can’t deduct because their income is too high to qualify.

In the case of those IRA contributions, at least, that would be a big mistake in some cases.  If there is no immediate tax benefit for a contribution, why make it?  Because at least the growth on that amount can be sheltered inside the IRA until it’s withdrawn.  Plus, those who don’t have any other money in traditional IRAs can take advantage of the backdoor Roth conversion strategy.  This strategy, in fact, is based primarily on the nondeductible traditional IRA contribution, so those contributions are becoming more common.  Traditional IRA account owners should consider the tax ramification, age and income restrictions in regard to executing a conversion from a Traditional IRA to a Roth IRA.  The converted amount is generally subject to income taxation.  

Clients often expect their IRA trustee to report the taxable and tax-free portions of IRA withdrawals.  However, that IRA trustee doesn’t necessarily know that the client didn’t take a tax deduction for his or her IRA contribution.  Even if they do know, the pro rata rule applies to all IRAs owned by a taxpayer, so when IRAs are spread across multiple firms, there’s no way a trustee could calculate the tax-free portion of the withdrawal.

That’s where IRS Form 8606 comes in, a form that serves multiple purposes.  First, it’s used by clients to let the IRS know they’ve made a nondeductible contribution to their traditional IRA.  It’s also used to track those contributions over time by keeping a running total.  Every year a client makes a non-deductible IRA contribution, they need to complete this form.

Second, this form is used to do the pro rata calculation needed to figure out the tax-exempt portion of the IRA withdrawal.  It also tracks the amount of contributions remaining in the IRA after each withdrawal to recalculate the tax-free percentage each year.

So, what happens when you have been making nondeductible contributions for years, but never bothered to report them on the 8606?  The good news is the IRS allows taxpayers to file these forms for prior years to catch up on their reporting.  The bad news: They must use the form for the year the contribution was made, which means digging through the IRS website to find old forms.  There is also a $50 penalty for each form filed after the normal filing deadline.

So, while you may think you are doing your tax preparer a favor by not mentioning your nondeductible IRA contributions, you are only possibly causing yourself grief down the road.  Form 8606 is the only way to ensure you get the full tax benefit of those contributions.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.