ComplianceTax & AccountingJuly 17, 2018

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:

  • A non-deductible (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 if that individual owns an IRA that contains non-deductible contributions or other basis (e.g., after-tax assets rolled over from an employer plan)
  • A traditional, SEP, or SIMPLE IRA-to-Roth IRA conversion is completed, or
  • A nonqualified distribution is taken from a Roth IRA.

Traditional IRA

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 of accumulating basis in an IRA is by rollover of after-tax assets from a qualified employer plan and/or repayment of 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 contain after-tax assets and he/she takes a distribution from any of his/her IRAs or beneficiary IRAs, 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 equal to the pretax amount is the taxable portion of the IRA distribution. Such distributions are appropriately reported in Part I of Form 8606. For this determination, distributions do not include amounts rolled over (with the exception of qualified disaster distribution repayments), qualified charitable distributions, a qualified HSA funding distribution, conversions, recharacterizations, or certain returned contributions.

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

Example: Katlyn made a nondeductible contribution into her traditional IRA for tax year 2016. When filing her 2016 tax return, she included IRS Form 8606 to report her $5,000 nondeductible contribution. That is the only nondeductible contribution (after-tax assets) she has in any of her traditional IRAs. The total balance, or fair market value (FMV), in all of Katlyn’s traditional, SEP, and SIMPLE IRAs is $20,000 at the end of 2018.

During 2018, Katlyn took $5,000 from one of her IRAs. When filing her 2018 tax return she included Form 8606 and wanted to claim that she did not owe tax on the entire $5,000. 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 2018 year-end balance is the $25,000 (the $20,000 FMV on December 31, 2018 plus the $5,000 distribution). Therefore, 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 and penalty-free amount of $1,000 (20 percent of the distribution amount), the amount attributable to basis.

Roth IRA conversions

A distribution from a traditional, SEP, or SIMPLE IRA that is deposited into a Roth IRA is a conversion contribution. 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 to determine whether any portion of a subsequent Roth distribution is subject to income tax and/or a penalty 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 distribution from a Roth IRA is not qualified, Form 8606 must be completed to determine whether any portion of the Roth IRA distribution is taxable and subject to the 10 percent early distribution penalty. For this purpose, a qualified 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, which begins with the first year for which a contribution was made to any Roth IRA, has been met. Non-qualified distributions would not meet this definition.

Penalties

Without reasonable cause, if an IRA owner fails to file a Form 8606 when required to, 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 at the time 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 the IRA owner. With this said, an IRA owner may not be aware he/she must file Form 8606. Because of this an IRA custodian/trustee may inform the IRA owner of the requirement and how it relates to the IRA as well as recommending the IRA owner see a tax professional for assistance.

Conclusion

As Form 8606 is an important IRA related form, it is important for an individual to understand when it must be filed 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 as well as 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 our 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.

Diana Theis
Senior Specialized Consultant, Tax Advantaged Accounts
With more than 30 years of experience, Diana has worked closely with hundreds of financial organizations to help them create, implement, and maintain their tax-advantaged accounts program.