Contributing to a traditional IRA is a great way to lower your tax bill. Unfortunately, not everyone qualifies for this deduction.
You don't have to itemize to deduct the amount you contributed to an IRA (and reduce your adjusted gross income dollar for dollar). But your income has to fall below certain levels to write off the full amount of your contribution. (Learn more about IRA contribution and deduction rules for your 2010 tax return and the rules for 2011.)
If your income exceeds the limits for the tax break, you still need to keep track of your after-tax (nondeductible) contributions by filing a Form 8606 with the IRS, according to the March issue of Kiplinger's Personal Finance magazine. Here's why:
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Filing a Form 8606 the years when you make nondeductible IRA contributions will be important when it's time to withdraw funds or if you convert to a Roth. Money that was already taxed is excluded from your taxable distribution or the taxable portion of the amount you convert on a pro-rata basis. For example, if you convert a $100,000 traditional IRA to a Roth and you made $10,000 in nondeductible contributions, 10% of the converted amount would be tax-free.
What if you haven't submitted the required form with your returns? You're in good company. Most people have never heard of Form 8606. You can file a form for past years and, although there's a $50 penalty for failing to file, it may be waived for reasonable cause. Call the IRS to explain your situation and ask how to proceed. Then, depending on how much money is at stake, you can decide whether it's worth the hassle of documenting earlier after-tax contributions.
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