Taxation
Avoid Double Taxation on Your IRA
Proposals to eliminate double taxation of dividends have received media coverage. Another source of double taxation is, however, less known but more important in some respects. The double tax occurs if already-taxed money is invested in a traditional IRA, and the investor fails to avoid taxes on that money upon distribution from the IRA.
There are very few barriers on a person's ability to contribute to an IRA. However, the Internal Revenue Service imposes many limits on deducting those contributions against income.
Quite often, a taxpayer may contribute the full amount toward a traditional IRA but then later discovers that only a portion can be deducted on tax returns. Current law limits or even eliminates the deduction if your income is over certain levels and if you are eligible for other retirement benefits. The amount that exceeds the limits is called a non-deductible contribution and must be reported on IRS Form 8606. Unfortunately, failure to properly report non-deductible contributions to traditional IRA's is one of the most common errors among taxpayers.
When you start to withdraw money from your IRA during retirement, the IRS assumes that all distributions from your IRA will be taxed unless you can show, with satisfactory evidence, that non-deductible contributions were made. Some IRA investors may need to store several decades of documents.
Form 8606 helps you and the IRS track the amount of your non-deductible contributions. For people who have been making IRA contributions since the 1980's, this form may be their only record of prior contributions. Common taxpayer mistakes are:
- Failure to report non-deductible contributions on Form 8606
- Failure to fill in line 2 on Form 8606 that reports the cumulative non-deductible contributions from prior years
- Failure to keep accurate proof of all prior non-deductible contributions to IRA accounts
Investors should not automatically fund their IRA's to the maximum allowable limit each year without understanding how much will be deductible against their income. It is often better to invest non-deductible money outside of retirement accounts, but that decision depends on details of the client situation now and in the future.
We assist our clients in tracking non-deductible contributions, so double taxation does not cause losses and headaches later.