We commonly don’t hear from clients for a little while as they’re humming along on the path to financial success. Life is good, they’re feeling confident with where they are putting their money, then it’s time to do taxes.

Unfortunately for some of them, this is the year their earnings have crossed the threshold where they are no longer able to contribute to their Roth account. What should they do with the money they put in there?  They have to take it out, but where does it go?

If you got to this point without a financial advisor, you need to have a discussion with one now, because the IRS thinks you’re wealthy and what you should do with that contribution is dependent on many factors which should not be covered in a blog entry.

This should not be taken as advice (again, call us), but we do find that many people are re-characterizing this ineligible contribution and sending the dollars to a Traditional IRA as a non-deductible contribution. Some people have been doing this for many years, say 15.

When we ask the client how much basis is in their IRA they often flatly do not understand what we’re talking about. Basis (in the context of this discussion) is money you already paid tax on that is in your IRA (the tax benefits of which are tax-deferred growth). The IRS doesn’t track it for you, neither does the investment company you are putting the money into. The investment company or firm has no idea whether your contribution is tax deductible or not. The responsibility falls solely on the client to track their basis.

Here is the problem:

Without properly tracking your basis, the money taken out of the Traditional IRA will be treated as 100% taxable by the IRS. This means you pay income taxes on the money twice, once before it went in, and again coming out. Good for the US Treasury, bad for you.

The tax item that tracks your basis is form 8606. Unfortunately, many people who are doing it are doing it improperly. The 8606 should aggregate prior year contribution with all previous years contributions as well.  The folly we normally see is just the amount that you contributed for the prior year on each years form.  You need that number but you should also add it to the carry forward amount for previous years contributions.

Here is the problem if you don’t do the 8606 properly:

You go 15 years making nondeductible contributions without tracking your basis properly. Your throw away all you tax returns older than 7 years. See the problem. Yes, you are in the horrible position of having to reconstruct your basis.

Reconstructing your basis can be done, but not without time, frustration, and (usually) money. In order to do this, you will have to compare your income history to your contribution history going back as far as you can, and work with an accountant so that you can amend your 8606 properly and notify the IRS, if they deem that is necessary.

We strongly encourage you to seek our advice regarding ineligible Roth contributions so we can present a customized strategy going forward. If you discover you’ve been doing your 8606 wrong (or not at all) we’re happy to look at your situation and get you the help you need.

Our financial advisors are also tax strategy consultants. We server the greater Memphis TN area, including Collierville, Germantown, Cordova, Bartlett, Lakeland, Arlington, Oakland, Hickory Withe and Millington.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss you specific tax issues with a qualified tax advisor.