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William Perez

Forgot to Claim IRA Deduction

By March 6, 2006

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Today's tax question comes from "J.F." in California. She asks, "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's a couple of things you can do now, depending on what you want to do with your retirement money and how you want it to be taxed. You have two basic options: claim an extra refund by amending your tax returns to take the IRA deduction, or file Form 8606 to declare these contributions as non-deductible IRAs and then later convert these funds to a Roth IRA. Either choice would be a smart tax move.

Some IRA Basics
You can have two sorts of Traditional Individual Retirement Accounts (IRA). You can make tax-deductible contributions (this is what most people do). Those contributions reduce your income. The contributions then grow tax-deferred until you retire. When you begin withdrawing money from the IRA, the withdrawals are included in your taxable income. Generally speaking, people who expect to be in a lower tax bracket during their retirement should be making deductible IRA contributions.

You can also make non-deductible contrbutions to a Traditional IRA. These contributions do not reduce your income. The contributions grow tax-deferred until retirement. When you begin withdrawing money, those non-deductible contributions come back to you tax free.

Many people prefer to contribute to a Roth IRA instead of a non-deductible IRA. With a Roth IRA, contributions are not tax-deductible. The contributions grow tax-free until you retire. When you begin withdrawing money from the Roth IRA, the withdrawals are completely tax-free (even the accrued interest and growth) as long as you've met all the requirements. Generally, people 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 Need to Make Now
So the first thing you get to decide: how do you want your IRA to be taxed? Do you want to take the tax deduction now, get some extra tax refund money, and then have this income be taxable when you retire? Or do you want to forget about the extra tax deduction, and 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, your contributions will be considered as if they were deductible IRA contributions. When you withdraw money in retirement, the funds will be taxed again. You'll end up paying tax twice on the same income. I'm pretty sure that you don't want to do that.

So, here's what to do, step-by-step.

If you want a tax deduction now (Deductible IRA)
File amended tax returns for 2002, 2003, and 2004 to claim the tax deduction for IRA contributions. You will get some extra tax refunds for each of those years. But file your 2002 amendment by April 17, 2006, or else your refund will be past the statute of limitations, and the IRS won't send you a refund check.

If you want to want tax-free withdrawals (Roth IRA)
File IRS Form 8606 to declare those IRA contributions as non-deductible. You will need to file Form 8606 for each year that you made contributions to your Traditional IRA but forgot to take the tax deduction. Then instruct your investment broker to convert your Traditional IRA into 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 prior to 2002
Follow the same procedure above for filing Form 8606 for each year. For tax returns over three years old, you cannot get any additional refunds from the IRS. So you will get no tax benefit by claiming a deduction for IRA contributions. So, just file Form 8606 to establish that these contributions are non-deductible. Then you are free to convert these funds to a Roth IRA.

Won't filing Form 8606 late raise red flags with the IRS?
I asked the IRS, and here's what they told me. 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 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
File Form 8606 to establish that the contributions were non-deductible, and then convert your funds to a tax-free Roth IRA. For returns in the last three years, you can choose whether to take the deduction and get a refund, or declare the contributions as non-deductible.

Essential Resources

Throughout the tax season I will be answering one tax question per day. Do you have a question? Visit the Ask a Tax Question page. Disagree with my answers? Post your comments in the Tax Forum.

Comments
October 23, 2008 at 8:59 pm
(1) Tim Moore says:

I have a question regarding nondeductible IRA situation?
In december 2005 I requested my financial advisors(F.A.) to deposit $300,000 of after tax savings into my savings acount with F.A.

They mistakenly deposied the savings into my IRA account.
I took my savings out as fast as possible (February, 2006) But F.A. files a sateement of early wirhdrawl from an IRA with IRS.

I tried to explain to IRS in my 1040 filing what had happened…. but the IRS are asking for income tax and penalties of about $160,000.

However, in a most recent letter they suggested that I file form 8606 part I.

Should I do this filing of Forn 8606, or does this legitimze the mistake made by F.A. in depositing my savings to wrong account and come back to bite me… I was aged 58 at february of 2006–when I receivered my savings back from IRA account via incompetent F.A.–who have since sold out the company at a fire sale a la Merrill Lynch.

January 9, 2009 at 7:25 pm
(2) taxes says:

Wow, what a mistake for the institution to make!

This situation is what we call an excess contribution. And there are three ways to correct the situation.

The easiest and most straightforward way to correct this is to withdraw the excess contribution you made for a particular year before the due date for that year’s tax return. In other words the excess contribution that happened in December 2005 should be withdrawn by April 15, 2006. Which in fact happened. In that circumstance, the tax law considers the original (mistaken) contribution as if it was never made. The Form 1099-R you received for the withdrawal should show code 8 in box 12. This code indicates that the funds with withdrawn because it was an excess contribution. When such funds are withdrawn, any earnings or interest or dividends on those funds must be withdrawn as well, which the financial institution usually calculates and reports to you.

If the institution did not code the 1099-R properly, then we have a serious problem. That’s because the default treatment of excess contributions is as follows:

The excess contribution is subject to a 6% excise tax for each year it is left inside the IRA; and when the excess funds are withdrawn they are subject to both the income tax and the 10% penalty for early withdrawal.

Ouch.

Withdrawing the excess funds by the due date of the return prevents this tax treatment. The corrective distribution (as it is called) is not subject to the income tax or to the 10% penalty for early distributions as long as the funds are withdrawn by the due date of the return.

Since the IRS is hounding you for taxes, I suspect there’s a problem in how the 1099-R was reported originally. So what I would do is document all the facts surrounding these events, develop a narrative explaining (1) this is an excess contribution, (2) the excess contribution was corrected before the due date of the tax return for that year, (3) therefore there’s no income tax or 10% penalty due on the corrective distribution. The most tax consequences is that any interest or dividends earned on the excess funds would be taxable, but that will be a minimal amount compared to the tax bill you are facing. In your narrative it will help to quote the Internal Revenue Code. For this situation, you should reference Code Section 408(d)(4).

Now an equally important part of your communication strategy is to get the right person at the IRS to review your situation. Likely you are dealing with people in collections. These agents are trained to collect unpaid taxes. They are good at what they do, but they aren’t trained always to equipped to handle situations where there’s an underlying problem with the way the taxes were calculated or reported. So I want you to do two things simultaneously. First, find your most recent letters from the IRS. Read through them and see if they provide a deadline for filing a collection due process hearing or for petitioning the Tax Court. If such a deadline is mentioned, make a note of it. Second, you are going to try get the IRS to solve this problem on two fronts. (a) Examine the 1099-R from the financial institution again. If it doesn’t have a code 8, call and write to the institution and ask them to re-issue the 1099. Make sure to document your discussions with them — name, date, what was discussed, what actions were taken, etc. (b) Make sure you request a collection due process hearing, or file an appeal, or petition the Tax Court by the deadline indicated on your letters.

Now don’t be afraid of all the legal-sounding phrases like “collection due process hearing” or “Tax Court”…. what this means is that your case will be routed to an appeals officer. This is an independent review function inside the IRS. Appeals officers are very highly trained, and they are trained to take a comprehensive look at a taxpayer’s situation when deciding what the most appropriate course of action would be. That doesn’t mean appeals officers are on your side, it does mean they will be more interested in hearing the whole story. Now all these methods (collection due process, Tax Court, appeals) all get routed through the Appeals office. So that’s the logical next step for you to be.

By the time you have a meeting with the appeals officer assigned to your case, make sure you’ve written a narrative detailing all the relevant facts in your situation, reference the tax code and how your actions corresponded to the provisions in that code section, and detail any administrative mistakes made by the financial institution. If the 1099-R was coded wrong, document that you asked the institution to correct it — and whether they did or not. Make sure your appeals officer has this narrative and any supporting documents well before your conference (which will likely be by phone). This will give the officer time to research the tax code, find out what can be done, he might even try to obtain documentation from the financial institution. In other words, you want to give the appeals officer an opportunity to find out for himself what happened.

I suspect that the appeals officer will then agree with you, and will revise your tax assessment accordingly. But do be prepared psychologically for the possibility that the appeals officer doesn’t agree with you. Be sure to ask questions and to provide answers and really try to explore all aspects of this. Even if the appeals officer disagrees, he may be open to settling on a smaller liability. In other words, there’s more room for negotiating and talking through the issues with appeals than anywhere else in the IRS system.

If you don’t obtain satisfactory resolution in appeals, then your case can be routed to the Tax Court. That’s a court of law, and a judge will review all the facts in your case and make a ruling. It is likely your case will never go before the judge, since the IRS attorneys will compile a case file and obtain all the relevant documents from the financial institution ahead of your court date, and if the facts fit this pattern for corrective distributions, they will likely try to settle this outside of the court system.

So basically, what I am saying here, is that you need to get your situation before the right people. And these are the sorts of review processes that can help you. Just make sure you do your homework ahead of time, and then steer your paperwork to the people inside the IRS that are mostly likely to help you.

November 16, 2010 at 9:02 pm
(3) John Kelly says:

You wrote: “If you want to want tax-free withdrawals (Roth IRA)
File IRS Form 8606 to declare those IRA contributions as non-deductible. You will need to file Form 8606 for each year that you made contributions to your Traditional IRA but forgot to take the tax deduction. Then instruct your investment broker to convert your Traditional IRA into a Roth IRA. The conversion may be partially taxable or completely tax-free, depending on how much your initial investments have grown. ”
I’d like to do this, I think. Can you tell me more about how the conversion taxable amount is determined? Does it matter that I converted a 503(b) to a Rollover IRA?
I contributed to a 503(b) for about five years in the early 1990s without claiming the tax deduction because I misinterpreted the instructions for form 1040. I left that employer in 1996 and have not made IRA contributions since except for starting a Roth IRA. Because of the timing and the US economy my contributions have grown considerably.
Thanks,
John Kelly

November 16, 2010 at 9:30 pm
(4) William Perez says:

It sounds to me like you are thinking about converting your rollover IRA (holding funds rolled over from your previous employer’s 403b plan) into a Roth IRA. Roth conversions are best analyzed by looking at the nature of the IRA funds you currently have and then figuring out the tax cost of converting those funds into a post-tax Roth account. My best guess, based on the information in your post, is that your rollover IRA consists entirely of pre-tax savings — in which case the entire value would be taxable if you convert to a Roth. Now you need not convert all the funds in your IRA. What I generally try to do is come up with a plan that will result in the lowest tax cost for getting funds converted to a Roth — and sometimes that means converting all the funds at once, and sometimes it means converting a little bit over multiple years. Look over my article on Roth conversions as I’ve put a lot of details into that article.

May 30, 2013 at 3:41 pm
(5) JT says:

I opened a traditional IRA at the beginning of 2012 because I didn’t have a 401k through my work. I then became eligible to contribute to my company 401k. When I did my taxes, I was only able to claim one or the other for tax deduction. I was not able to claim for traditional IRA so my question is, if I close that traditional IRA will I have to pay taxes on that income even though I never claimed a deduction for the money deposited?

August 1, 2013 at 11:49 am
(6) EllieJo says:

Great advice, thanks you! I’m interested to hear if the IRA can be left as an IRA, as the advice above says to convert to a Roth after filing the 8606.

I don’t meet Roth requirements, and would like to know that when I withdraw in retirement I don’t pay tax again.
If I file the 8606, can I keep it as an IRA?

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