What To Do If You Forgot To Claim Your IRA Deduction

The tax code is complicated. It's easy to forget or overlook tax-planning moves and steps, 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.

Deductible IRA Contributions

You have two options 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.

Nondeductible IRA Contributions

You can also make nondeductible contributions to a traditional IRA. These 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 will 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 59½ years old or older as of the date of the withdrawal. Exceptions exist if you're disabled or a first-time homebuyer, or for your beneficiaries after you die. The Internal Revenue Service (IRS) also makes occasional exceptions to the early-withdrawal taxation for taxpayers who are affected by natural disasters. These are typically focused on a certain part of the population and they're temporary. They'll vary from one year to the next.

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.

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. The IRS wouldn't send you a check in this case.

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 If you made contributions more than three years ago. File 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 those IRA contributions at this point. Just file Form 8606 to establish that these contributions are nondeductible so that you're free to convert the funds to a Roth IRA.

Will Filing Form 8606 Risk an Audit?

"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," said Jesse Weller, a spokesperson for the IRS. "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 2 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.

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