People who expect to be in a lower tax bracket at retirement age typically make deductible IRA contributions and enjoy tax benefits until retirement.
You can also make non-deductible contributions to a traditional IRA. These contributions do not reduce your income for tax purposes, but they will increase tax-deferred until your retirement. Contributions for which you do not claim a deduction are returned to you tax-free when you start withdrawing money.
Roth IRAs vs Non-Deductible IRAs
Many people choose to contribute to Roth IRAs rather than making nondeductible contributions to traditional IRAs. Roth IRA contributions are also non-deductible, and they also grow tax-free until retirement. When you start withdrawing money from a Roth IRA, you are completely exempt from taxes, even accrued interest and growth, provided you meet all the requirements.
You must have held the account for at least five years and be aged 59 1/2 years or older on the date of withdrawal. Exceptions are when you are disabled or buying a home for the first time, and for your beneficiaries after your death.
People generally choose to contribute to a Roth IRA if they expect to be in the same or higher tax bracket after retirement.
The decision you must make
You must decide how you want your IRA to be taxed if you forgot to claim IRA deductions in previous years.
You can take advantage of the tax credit now, get some extra money for your tax refund, and then tax that income later when you retire and withdraw money. Or you can forget about the tax deduction now and get tax-free money later.
A tax professional can help you determine which option is best for your circumstances, and you’ll want to consult with them to make sure you fully understand all of the outcomes of your choices.
What if nothing is done?
The IRS will treat your contributions as deductions unless you make a decision. The funds will be taxed when you withdraw money at retirement as it was deductible when you deposited it. You can avoid this by taking an extra step.
If you would like to withdraw now
File amended tax returns for all years that can still be amended according to the statute of limitations set by the Internal Revenue Service. This is usually three years from the filing date of the return or two years from the date of the last payment on the return, whichever is later.
Claim tax deductions for IRA contributions on your amended return. You may receive additional tax refunds for each of these years. File your amended returns before the tax due date for the current year, or the return period may expire and the IRS will not send you a check.
If you would like to receive tax-free withdrawals
File IRS Form 8606 to declare your IRA contributions as non-deductible if you want tax-free payments. You must file Form 8606 for each year you contributed to a traditional IRA but forgot to use the deduction.
Then have your investment broker convert your traditional IRA into a Roth IRA. The conversion can be partially taxable or completely tax-free, depending on how much your initial investment has grown.
Convert to Roth IRA
Follow the same process for filing Form 8606 for each year if you contributed more than three years ago.
You cannot receive an additional refund from the IRS for tax returns more than three years old, so you will not receive tax benefits by claiming a deduction for IRA contributions now. Simply fill out Form 8606 to establish that these contributions are non-deductible and you will be able to convert the funds to a Roth IRA.