Tax Planning

Experts highlight the tax issues every financial adviser should know

Taxpayers only hurting themselves by not mentioning their nondeductible IRA contributions

There's only one way to ensure they get the full tax benefit of those contributions

Mar 22, 2017 @ 1:01 pm

By Tim Steffen

By now nearly all taxpayers have begun the arduous task of compiling the information needed to prepare their 2016 tax return, including sifting through receipts and statements to determine what's needed for the return and what is just noise. That's 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 going through useless information. In those cases, clients may be tempted to not include things they think won't impact their return, like, for example, the IRA contribution they know they can't deduct because their income is too high to qualify.

(More: Tax reform could be 'way worse' for retirement industry than Department of Labor's fiduciary rule)

In the case of those IRA contributions, at least, that would be a big mistake.

THE IRS NEEDS TO KNOW

First, let's quickly review the rules on deducting IRA contributions. Taxpayers who aren't covered by an employer retirement plan can always deduct their contribution, but those who are covered are subject to an income limit. For 2016, married couples with modified adjusted gross income over $98,000 (and singles over $61,000) begin to lose the ability to deduct their contribution.

If there's no immediate tax benefit for 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 Because at least the growth on that amount can be sheltered inside the IRA until it's withdrawn.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. In fact, that strategy is based primarily on the nondeductible traditional IRA contribution, so those contributions are becoming more commonplace.

While the growth on those contributions is taxable when withdrawn, the contribution itself is withdrawn tax-free, albeit on a pro rata basis with any pre-tax funds in the IRA. And therein lies the reason why clients need to tell their tax preparer about these contributions: How does the IRS know that there really is after-tax money inside the IRA?

(More: Faltering congressional support for auto-IRAs leaves legislation up to states)

Taxpayers often expect their IRA trustee to report the taxable and tax-free portion of IRA withdrawals. However, that IRA trustee doesn't necessarily know that the client didn't take a tax deduction for their IRA contribution. Even if they do, 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.

FORM 8606 TO THE RESCUE

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 nondeductible 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 in order to recalculate the tax-free percentage each year.

So what happens when your client has 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 in order to catch up on their reporting. The bad news: They have to use the form that was issued 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 that was filed after the normal filing deadline.

(More: Donald Trump vs. Bill Clinton: Same age, but different IRA rules)

So, while taxpayers may think they're doing their tax preparer a favor by not mentioning their nondeductible IRA contribution, they're only hurting themselves. Form 8606 is the only way to ensure they get the full tax benefit of those contributions.

Tim Steffen is director of financial planning for Baird. Follow him on Twitter @TimSteffenCPA.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

Apr 30

Conference

Retirement Income Summit

Join InvestmentNews at the 12th annual Retirement Income Summit - the industry's premier retirement planning conference.Much has changed - and much remains to be learned. Attend and discuss how the future is full of opportunity for ... Learn more

Featured video

Gadget Girl

Orion's Clarke: Why integration is paramount for RIAs right now

Orion has tapped into a huge demand for customizable, integrated solutions that let advisers spend more time building their business. Hear from Eric Clarke and two of Orion's integrated partners to get their thoughts.

Latest news & opinion

Meet our 2017 Women to Watch

Introducing 20 female financial advisers and industry executives who are distinguished leaders, advancing the business of providing advice through their creativity and hard work.

Raymond James executives call on industry to keep broker protocol

Also ask firms to pay for the administration of the protocol to 'ensure its longevity and relevance.'

House passes tax bill, focus turns to Senate

Tax reform legislation expected to have more of a challenge in upper chamber.

SEC enforcement of advisers drops in Trump era

The agency pursued 82 cases against advisers and firms in fiscal year 2017, down from 98 the previous year.

PIABA accuses Finra of conflicts of interest

Public Investors Arbitration Bar Association report slams self-regulator over its picks for board of governors.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print