Arthur Godfrey was known to say, “I’m proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money”
Considering that quote, I’m thinking Mr. Godfrey wouldn’t be too pleased if he was taxed twice on the same money.
And yet, many people do pay taxes twice on the same source of income.
This generally applies to those that have a C-Corporation.
Double taxation can occur when income earned by a corporation, is taxed, and then is paid out in dividends to their shareholders who pay taxes as well.
There are also situations where one lives in one state and earns income in another state. Although you may not experience double taxation, you may need to file multiple state tax returns.
If you live overseas and are a US citizen, there could be other special tax considerations you should talk to your CPA about as this can add even more complexity.
The double taxation I want to talk about today is something that might affect everyone regardless of what state (Or country) you live in, work in, or even if you have a C-Corporation.
A couple of weeks back, I spoke to a couple that reached out to talk about retirement. Since they wanted to stop working at the end of the year, they thought it would be a good idea to see if that was possible financially.
They both worked in the medical field for over 20 years and were high income earners.
They shared some financials with me via Zoom and mentioned on top of participating in a 401k, that they had both been maxing out contributions to their IRA’s for over 20 years.
Looking at their Social Security statements, I noticed they were very high-income earners for decades. This is a great thing for Social Security benefits, as Social Security takes ones 35 highest earning years to base the amount of benefit one would receive. (Click on the link at the end of this blog, “5 Social Security Myths” to learn more.)
But that got me thinking when I looked at their IRA balances. Once I confirmed that these balances consisted strictly of contributions and not any rollovers from other retirement plans, I wondered if they had been deducting these IRA contributions each year on their taxes.
This year, in 2022, if an individual has a retirement plan at work (Like a 401K) and their Adjusted Gross Income is over $68,000 (Or over $109,000 married filing jointly), then they wouldn’t be eligible to fully make a deductible IRA contribution.
Bear in mind, that with the passing of the Tax Reform Act of 1986, these income limits were much lower (People made less money in 1986 and these limits have increased over the years)
So, it got me thinking, were these high-income earners taking a tax deduction each year on these IRA contributions when they weren’t eligible to do so?
Since they didn’t know the answer to this question, and we didn’t have access to their tax returns on our call, (And we couldn’t hop on a call with their CPA at that moment), we decided we should look into that. In fact, the call to their CPA might help for recent years however, they hadn’t been working with her long so we would need to do a bit more detective work on our own.
When one makes an IRA contribution that doesn’t allow for a deduction due to higher income and having a 401k plan at the same time, they are supposed to file an IRS Form 8606 so the IRS can keep track of these non-deductible IRA contributions.
Why is this important?
Well, you could be subject to double taxation.
It works like this:
Fred and Wilma* have an Adjusted Gross Income in 2022 of $400,000. Well above the limit of $109,000. (And they each have a 401K at their jobs). Oh, and if only one spouse has a 401k, the rules are a bit different.
They can still make an IRA contribution, but they can’t deduct it. Since they already paid tax on the $6,000 (Maximum contribution limit if under age 50) they each put in their respective IRA’s, when they take the money out years later, they would only pay tax on anything above the $6,000 they each put in.
But only if Fred and Wilma filed the IRS Form 8606
If the IRS doesn’t know these were nondeductible contributions, not only would the growth on the $6,000 be taxable but also the $6,000 initial contribution.
If it turns out these IRS form 8606’s weren’t filed each year, not all is lost. If one keeps old records, there might be form 5498’s or IRA statement to be found that show when one made a contribution and then by looking at that year’s tax return, we can see if a deduction was taken. One can also request a Wage and Income transcript from the IRS to help show a contribution was indeed made and wasn’t deducted.
Rick’s Tip!: Be sure to tell your tax preparer each year if you make a contribution to an IRA (Not everyone seems to get (or keeps) those form 5498’s that show a contribution was made)
Feel free to reach out to me if you have any questions. I’m here to help.
Here’s another piece you may find of interest “5 Social Security Myths” Click HERE
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All the best.
Rick Fingerman, CFP®, CDFA™, CCPS®
*Not their real names
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.