As taxes on investment income rise, strategies are needed to shelter income. Company retirement plans offer the most obvious choice to defer income. Roth IRAs also harbor investment earnings, tax free. Unfortunately, when modified adjusted gross income exceeds $191,000 for those married filing jointly (or $129,000 if filing single), the ability to contribute to a Roth IRA is phased out.
For high income individuals, contributing to a non-deductible IRA can also defer investment earnings. In 2014, the maximum contribution is $5,500 if you are under age 50, or $6,500 if you are over age 50.
Because there is no tax deduction for these contributions, they are not taxed when withdrawn. So how do you know when non-deductible contributions are withdrawn from IRA accounts that house different sources of money, perhaps from 401K rollovers, non-deductible contributions, or earnings?
In any year that an individual makes a non-deductible IRA contribution, they are required to file Form 8606 with their income tax return. This form keeps track of all non-deductible contributions and forwards this information to the IRS. When funds are withdrawn, a percentage is used to calculate the tax-free portion of the withdrawal. For example, if you have an IRA worth $100,000, and you contributed $20,000 in non-deductible contributions, the tax-free portion of any distribution will be 20%. So, in this example, a $10,000 distribution will break down into an $8,000 taxable amount and a $2,000 tax-free amount.
What should you do if you have forgotten to file Form 8606? You will need to recreate Form 8606 by providing proof of prior contributions, as well as proof there was no deduction on page 1 and 2 of Form 1040 of your tax return. Form 8606 can be sent to the IRS as a freestanding form. Keep in mind there is a $50 penalty if you fail to file the form, and a $100 penalty if you overstate non-deductible contributions (unless you can show reasonable cause).
If you don’t have your tax return, you can request a transcript on the IRS’ website. Note that 1987 was the first year nondeductible contributions were allowed, and 2002 was the first year the contribution limit exceeded $2,000. Another form that may be useful is Form 5498. This form is sent to account owners by IRA custodians and trustees in May, and indicates the amounts contributed to an IRA. Your monthly statements may also reflect annual IRA contributions.