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ComplianceTax & AccountingFebruary 19, 2021

Individual retirement accounts: When is IRS Form 8606 required?

Overview

A form commonly used in conjunction with individual retirement account (IRA) activity is Internal Revenue Service (IRS) Form 8606, Nondeductible IRAs. An individual is responsible for filing Form 8606 each year that:

  • A nondeductible (i.e., after-tax) regular contribution is made to a traditional IRA
  • A distribution from any traditional, simplified employee pension (SEP), or Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRA is taken, and that individual owns (or is the beneficiary of) an IRA that contains nondeductible contributions or other basis (e.g., after-tax assets rolled over from an employer plan)
  • All or a portion of a traditional, SEP, or SIMPLE IRA was transferred from an IRA of one spouse to an IRA of the other spouse due to a divorce or separation instrument, and the transfer resulted in a change of basis for either spouse
  • A traditional, SEP, or SIMPLE IRA-to-Roth IRA conversion is completed, or
  • A nonqualified distribution is taken from a Roth IRA.

Traditional IRA contributions

If an IRA owner does not claim a deduction for a regular contribution, the amount contributed is after-tax and is considered basis. Therefore, the IRA owner must file IRS Form 8606 for the year of the contribution to inform the IRS that the contribution is nondeductible. Part I of Form 8606 keeps track of this IRA basis.

Other methods by which basis is accumulated in an IRA is by rollover of after-tax assets from a qualified employer plan and/or repayment of a qualified reservist or disaster distribution(s). An individual is not required to file Form 8606 for the year an employer plan-to-IRA rollover deposit is made if a portion of the rollover is after-tax. However, the IRA owner must keep appropriate records for future Form 8606 filing.

Traditional IRA distributions

When an IRA owner (or beneficiary) has any traditional, SEP, or SIMPLE IRA which contains after-tax assets and he/she takes a distribution from any of his/her IRAs (or beneficiary IRAs) or completes a conversion, Form 8606 must be filed for such year. The form is used to determine the prorated after-tax and pretax amounts distributed. The after-tax amount is distributed tax-free and penalty-free. The portion of the distribution that is attributable to the pretax amount is the taxable portion of the IRA distribution. Such distributions are reported in Part I of Form 8606. For completing Part 1, distributions do not include amounts rolled over (except for qualified disaster distribution repayments), qualified charitable distributions, a qualified HSA funding distribution, conversions, recharacterizations, or certain returned contributions. However, Part 1 must be completed if a portion of an individual’s traditional, SEP, and SIMPLE IRA assets are converted to a Roth IRA.

Failure to file Form 8606 for a distribution could result in the IRA owner (or beneficiary) paying income tax and the additional 10 percent early distribution penalty tax on amounts that should be tax-free.

Example: Katlyn made a nondeductible contribution to her traditional IRA for tax year 2017. When filing her 2017 tax return, she included IRS Form 8606 to report her $5,000 nondeductible contribution. That is the only nondeductible contribution she has ever made to any of her traditional IRAs and the only after-tax amount in her traditional IRAs. The total balance, or fair market value (FMV), in all of Katlyn’s traditional, SEP, and SIMPLE IRAs at the end of 2020 is $20,000.

In 2020, Katlyn took $5,000 from one of her IRAs. When filing her 2020 federal income tax return, she included Form 8606 and intended to claim the entire $5,000 as non-taxable. However, the taxation of the $5,000 is based on the proportions of her total pretax and after-tax amounts versus the year-end balance. For Form 8606 calculation purposes, the adjusted 2020 year-end balance is $25,000 (i.e., the $20,000 FMV on December 31, 2020 plus the $5,000 distribution). Therefore, based on the December 31, 2020 FMV, 80 percent of her IRA assets are pretax, and 20 percent of her IRA assets are after-tax. The distribution amount of $5,000 results in a taxable amount of $4,000 (80 percent of the distribution amount) and a tax-free amount of $1,000 (20 percent of the distribution amount), the amount attributable to the basis.

Roth IRA conversions

A distribution from a traditional, SEP, or SIMPLE IRA deposited to a Roth IRA is a conversion contribution. The amount distributed is subject to the prorated taxation rules described above. An individual may also have regular contributions and earnings in a Roth IRA. Part II of Form 8606 is used to account for the converted amounts and determine whether any portion of a subsequent Roth distribution of converted assets is subject to an additional 10 percent early withdrawal/distribution tax, sometimes referred to as a recapture tax.

Roth IRA distributions

Distributions from a Roth IRA are reported in Part III of Form 8606. If a distribution is a qualified distribution, it is not necessary to complete Form 8606. If a Roth IRA distribution is not qualified, Form 8606 must be completed to determine whether any portion of the Roth IRA distribution is taxable and subject to the additional 10 percent early distribution penalty tax. For this purpose, a qualified Roth IRA distribution is a distribution after a Roth IRA owner attains age 59½, after his/her death, or after his/her disability, AND a five-year holding period is met. The five-year holding period begins with the first year for which a Roth IRA contribution was made. Nonqualified distributions would not meet this definition.

Penalties

Without reasonable cause, if an IRA owner fails to file a Form 8606 when required, the IRA owner owes a $50 penalty. Additionally, if an IRA owner overstates his/her nondeductible contribution amount on Form 8606 without reasonable cause, a $100 penalty is owed.

Responsibility

It is an IRA owner's responsibility to maintain accurate records allowing proper and timely completion of Form 8606 when he/she files his/her federal tax return. If an individual is not filing a federal tax return, Form 8606 is filed at the time and place a tax return would otherwise have been filed. It is not an IRA custodian/trustees’ responsibility to inform an IRA owner of the need to file Form 8606 or provide the form to an IRA owner. With this said, an IRA owner may not be aware he/she must file Form 8606. Thus, an IRA custodian/trustee may inform the IRA owner of the requirement and how it relates to the IRA and recommend the IRA owner see a tax professional for assistance.

Conclusion

As Form 8606 is an important IRA related form, an individual needs to understand when to file it with his/her tax return. An IRA owner and his/her tax professional should be aware of what records to keep from year to year and when and how to complete the form. For more information, go to irs.gov and read the instructions for Form 8606.

For an opportunity to learn more about IRAs and other tax-advantaged accounts, including Health Savings Accounts and Coverdell Education Savings Accounts, consider the Wolters Kluwer IRA Library or on-demand video training offered on a variety of topics. Go here to learn more about training opportunities available to you or call us at 1-800-552-9408.

Mike Schiller
Manager, Specialized Consulting, Tax Advantaged Accounts
With more than 22 years of experience, Mike has worked closely with hundreds of financial organizations to help them create, implement, and maintain their tax-advantaged accounts program.