ISSUE 143: Special Section

Know A Good Doctor? We Do.

Scott Neal

Scott Neal, CPA, CFP, is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Reach him at scott@dsneal.com or by calling 1.800.344.9098.

Remember the IRA?

I once heard about an old CPA who, after presenting a completed tax return to his client, said, “Don’t read the {expletive deleted} thing, just sign it.” Unlike that guy, before I gave up my tax practice, I would remind clients to make sure that they understood what was on the return so that it could be as complete and accurate as possible. I know that the tax code is much more complex these days, but you should read and understand your 1040.

Unless you are different than most people I know, you probably don’t volunteer to pay extra taxes. Guess what? If you haven’t kept track of your non-deductible contributions to your Individual Retirement Account (IRA), you may pay more taxes than you should when you turn 70-1/2. This column is meant to be a quick refresher on IRAs—not exhaustive by any means—but will be important to many of our readers. Bear with me for what could be very good news for some of you.

Traditional IRAs came into existence in 1974 and were initially only available to taxpayers who were not already covered by a qualified retirement plan. Contributions were originally limited to $1,500. The Economic Recovery Tax Act of 1981 lifted the qualified plan restriction, and taxpayers could contribute and take a tax deduction of up to $2,000 on their own account, plus $250 for a nonworking spouse. Deductions began to be phased out under the Tax Reform Act of 1986 for IRA contributions made by high-income taxpayers who were also covered by a retirement plan, or had a spouse covered by one. Additional changes were written into law in the late ‘90s. Income limits were raised, allowing more people to make contributions.

The Taxpayer Relief Act of 1997 introduced the ROTH IRA, a special kind of retirement account. Contributions to ROTH IRAs are made with after-tax dollars. There is no deduction taken for the contribution and no taxes paid on the distribution, so long as all the rules have been met. However, the ability to make contributions to ROTH IRAs is phased out for higher earning taxpayers. Deductions for Traditional IRAs are also eliminated for certain taxpayers. But anyone who has “earned” income can still make contributions to a Traditional IRA up to the limits (presently $5,500 or $6,500 for people over 50). The deduction, not the contribution, may be eliminated based on income.

Non-deductible contributions still make sense for most taxpayers.

Our recommendation is to first test to see if you can make a deductible contribution to a Traditional IRA. If so, make the contribution and get the benefit of the deduction. The phase-out of the deduction happens at different levels of income, depending on filing status (joint, single, or head of household) and whether you or your spouse are covered under a retirement plan. If you are phased out of the deduction due to the income limits, you should then test to see if you can make a ROTH contribution. If your income is also too high to make a ROTH contribution, you should still be able to make a non-deductible contribution to a Traditional IRA if you have had earned income.

Remember that distributions from Traditional IRAs are required beginning at age 70-1/2, and they are fully taxable unless you can prove that you have tax basis in the IRA. Making a non-deductible contribution to an IRA creates tax basis. These should be reported on Form 8606 of the tax return for the year in which the non-deductible contribution is made. If you skip a year of making the contribution there will be no 8606 for that year. This means that the carry forward information regarding basis is very easily overlooked in subsequent years. We have even seen taxpayers and preparers who simply fail to report the non-deductible contribution. Non-reporting seems very logical to some people since the contribution has no present tax consequence. But who would ever think that the tax code was built on logic?

The responsibility for keeping track of basis rests with the taxpayer, not the government, and not the custodian of your IRA. Herein lies a potential problem, with a corresponding opportunity to avoid paying unnecessary taxes in the future, if you act now. Let’s say you made tax-deductible IRA contributions early in your career, and non-deductible contributions for the past several years. As distributions are taken throughout retirement, a portion of each distribution is considered a non-taxable return of basis. If you cannot prove your basis, the government can claim that the entire distribution is taxable. If you think that you have this problem, now is the time to get it fixed.

If you have made a non-deductible contribution to your IRA, pull out your tax return and find the Form 8606. On line 2 of that form you should find your total basis in all Traditional IRAs. If you have not yet taken distributions from your IRA, this should be the amount of your lifetime accumulated non-deductible contributions to any Traditional IRA. If it doesn’t look right, now is the time to discuss it with your tax preparer.

Scott Neal, CPA, CFP, is the president of D. Scott Neal, Inc. a fee-only financial planning and investment advisory firm. You may subscribe to his blog at
www.dscottneal.com. Or simply call 1-800-344-9098 or email to
scott@dsneal.com
with questions or comments.