Contributing to an Individual Retirement Account (IRA) can be a smart way to prepare for retirement while potentially gaining tax advantages. However, not all IRA contributions are tax-deductible. In some cases, particularly if you or your spouse are covered by a retirement plan at work and your income exceeds certain limits, your traditional IRA contributions may be nondeductible. Understanding how to report nondeductible IRA contributions is crucial to avoid being taxed twice on the same money when you eventually withdraw it in retirement.
Understanding Nondeductible IRA Contributions
What Are Nondeductible IRA Contributions?
A nondeductible IRA contribution is money you contribute to a traditional IRA that you cannot deduct from your taxable income for the year. This usually occurs when your modified adjusted gross income (MAGI) is too high and you or your spouse are covered by a workplace retirement plan. Even though these contributions do not reduce your current tax bill, they still help your retirement grow tax-deferred.
Why Reporting Matters
Failing to report nondeductible IRA contributions can lead to double taxation. The IRS assumes all withdrawals from a traditional IRA are fully taxable unless you tell them otherwise. By reporting your basis (the after-tax contributions) accurately, you ensure that you are only taxed on the growth or earnings when funds are withdrawn.
When to Report Nondeductible IRA Contributions
Timing Is Important
You must report nondeductible IRA contributions for the tax year in which the contributions were made. If you contribute to your IRA in early April but designate the contribution for the prior tax year, it should still be reported on the prior year’s return. This helps maintain a clear and accurate tax record.
Annual Filing Requirement
Every year you make a nondeductible contribution, you are required to file IRS Form 8606 with your federal tax return. This form tracks your nondeductible contributions over time, ensuring your ‘basis’ in the IRA is properly recorded.
How to File IRS Form 8606
What is Form 8606?
IRS Form 8606, titled ‘Nondeductible IRAs,’ is used to report nondeductible contributions to traditional IRAs and to calculate the taxable portion of distributions. It is also used in cases involving Roth IRA conversions or distributions from Roth IRAs, but our focus here is on its use for traditional IRAs.
Steps to Complete Form 8606
Here’s a simplified breakdown of how to report nondeductible IRA contributions:
- Part I: Enter your total traditional IRA contributions and the portion that is nondeductible.
- Line 1: Shows the total contribution for the year.
- Line 3: Enter the amount that is nondeductible.
- Line 14: This line keeps a cumulative record of your nondeductible contributions your IRA basis.
You must attach Form 8606 to your federal tax return (Form 1040 or 1040-SR) and file it by the tax filing deadline, typically April 15th.
If You Forgot to File Form 8606
If you made a nondeductible IRA contribution in a previous year and didn’t file Form 8606, you should file it now. The IRS allows late filing, though you may face a $50 penalty for failing to file. More importantly, it’s in your best interest to correct the oversight to prevent future tax issues.
Understanding the Tax Implications
How Withdrawals Are Taxed
When you start taking distributions from your traditional IRA, you must report them as income. However, if you have properly reported nondeductible contributions, only the earnings are taxable. Your basis the amount you contributed with after-tax dollars is not taxed again.
To determine how much of a distribution is taxable, you use the pro-rata rule. This rule means that each distribution contains a mix of pre-tax and after-tax amounts based on the total value of your IRA and your basis.
Pro-Rata Rule Example
Suppose you have $100,000 in your IRA, which includes $20,000 of nondeductible (after-tax) contributions. This means 20% of each distribution is tax-free. So if you withdraw $10,000, $2,000 will not be taxed, and $8,000 will be subject to income tax.
Common Mistakes and How to Avoid Them
Not Filing Form 8606
This is the most frequent error. If the form is not filed, the IRS assumes all IRA contributions were deductible and all withdrawals are taxable. This mistake can cost you significantly in overpaid taxes.
Confusing Roth and Traditional IRAs
Some taxpayers mistakenly believe they can deduct contributions to a Roth IRA or that Roth contributions need to be reported on Form 8606. While Roth conversions do appear on the form, regular Roth contributions are not reported here.
Misreporting IRA Basis
It’s important to keep a running total of your nondeductible contributions over the years. Any incorrect information on your IRA basis can lead to incorrect taxation when you start withdrawing funds.
Best Practices for Accurate Reporting
Keep Detailed Records
Maintain copies of all Form 8606 filings, contribution confirmations from financial institutions, and notes on which year each contribution was for. This helps you verify your basis if needed in the future.
Use Tax Software or a Professional
Tax software can automatically fill out Form 8606 when you enter a nondeductible IRA contribution. Still, if your situation is complex or involves multiple accounts, working with a CPA or tax advisor may be worth the investment.
Understand Income Limits
Before making a traditional IRA contribution, know the income limits for deductibility. If you or your spouse have a retirement plan at work and your income is too high, your contributions may be nondeductible. In such cases, reporting them correctly becomes even more critical.
Why Nondeductible IRAs Still Matter
Building Tax-Deferred Savings
Even if your contribution isn’t deductible, a nondeductible IRA can still grow tax-deferred. That means you won’t pay taxes on investment earnings until you withdraw the funds, allowing your money to grow faster over time.
Backdoor Roth Strategy
High-income earners who are ineligible to contribute directly to a Roth IRA often use the ‘backdoor Roth IRA’ strategy. This involves making a nondeductible contribution to a traditional IRA and then converting it to a Roth IRA. Properly reporting the initial nondeductible contribution is key to avoiding taxes on the conversion.
Reporting nondeductible IRA contributions is essential for accurate tax planning and to avoid overpaying taxes during retirement. Although these contributions don’t reduce your taxable income now, they play a crucial role in long-term savings strategies and in reducing future tax burdens. By filing IRS Form 8606 each year you contribute, keeping track of your IRA basis, and understanding how these contributions affect withdrawals, you can make the most of your retirement planning while staying fully compliant with IRS rules.