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."
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.
- Traditional IRAs
- Roth IRAs
- IRS Publication 590, Individual Retirement Arrangements
- IRS Form 8606, Nondeductible IRAs (PDF)