It is safe to say that no one enjoys overpaying taxes – except maybe Uncle Sam, who will gladly accept these extra dollars in their coffers. However, most taxpayers report all IRA withdrawals as taxable distributions on their tax returns, when in fact some of the money withdrawn often consists of nondeductible (after-tax) distributions. These types of withdrawals are not subject to income taxes. It’s easy to lose track of these after-tax contributions but the IRS, by default, will consider all distributions taxable as ordinary income, unless precise tax records are kept. All too often many after-tax contributions are lost when taxpayers either forget that these amounts were after-tax or do not track and report them correctly on their tax returns.
To avoid the double taxation of amounts withdrawn from an IRA’s nondeductible contributions, you or your tax preparer need file an IRS Form 8606, Nondeductible IRAs. This form is designed to eliminate any confusion and track the taxability of your contributions. Most taxpayers run into problems when they haven’t completed and filed a Form 8606 over the years. The result is lost basis and a potential overpayment in taxes.
Can this be remedied? Absolutely. It will take some digging in old tax files, but it is possible to quantify the amount of past nondeductible contributions, even if you’re starting from scratch. You may conclude that it’s not worth the hassle. First, though, you should make a ballpark estimate of the amount of money involved. For those who have regularly contributed over the years, it could amount to tens of thousands of dollars – especially for higher income individuals. Once you have done your homework and are back on track, this will prove a great impetus to start keeping track of future nondeductible IRA contributions, not to mention provide a modicum of future tax savings and peace of mind.
Smart Money Tips
- Keep your eyes on the retirement prize. Everything you do in your financial life, from saving to investing, from obtaining insurance to controlling your debt is geared toward one overriding goal: to be able to afford to retire and, once you’re retired, to thrive financially throughout your retirement years. Arranging your financial life around that goal is not something that is best begun a year or two before retirement – or forgotten a year or two after you retire. The earlier you begin to think of all aspects of your financial life in the context of retirement, the better able you will be to retire in fine fettle.
- It’s time to practice “Reverse keeping up with the Joneses.” As the economy gets back to normal, consumers have rekindled their longstanding propensity to spend lots of money. If your neighbor starts spending like there’s no tomorrow, you may fear being derided about your less-than-spectacular lifestyle. But instead of trying to keep up with the Joneses, we recommend that our disciples practice the reverse. In other words, while it’s important for us as a nation to spend abundantly since consumer spending is essential to fueling the economy, you don’t have to be a good citizen in this instance. Therefore, our advice is to simply sit back and let your neighbors, friends, and everyone else consume with alacrity while you quietly restrain your spending. Then we have the best of both worlds – robust consumer spending spurring the economy while you’re saving for a more prosperous future.
Food for Thought
If we did all the things we are capable of doing, we would literally astound ourselves.
–Thomas Edison
Money Can Be Funny
There are more important things in life than a little money, and one of them is a lot of money.
–Anonymous
Word of the Week
parergon (par-RUR-gon) – Work that is extra to one’s ordinary job; a “moonlighting” job.
Origin: From the Greek paregios < para meaning besides, and ergon meaning work. Hence the literal meaning “besides work.”
My daughter’s parergon is tutoring students who, like many of us in the past, are struggling with grammar.