How and When to File IRS Form 8606 for Nondeductible IRAs

Internal Revenue Service (IRS) Tax Form 8606, Nondeductible IRAs is used for Roth individual retirement accounts (Roth IRAs) and the rollover eligibility of after-tax assets from qualified plans offered by employers, such as a 401(k) or a 403(b). The filing of this form affects tax liabilities. The main consequence of failing to file the form is tax penalties.

A Form 8606 must be filed every year when you contribute after-tax amounts (nondeductible contributions) to your traditional IRA. Conversions from traditional, Simplified Employee Pension (SEP), or Savings Incentive Match Plan for Employees (SIMPLE) IRAs also must be reported on Form 8606. Additionally, you must file the form every year when you receive a distribution from your Roth IRA or traditional IRA if you have ever previously contributed after-tax amounts.

Understanding Nondeductible IRA Contributions

The taxability of your retirement account distribution is usually determined by whether the assets are attributable to pretax or after-tax contributions. If your assets are in a qualified plan with your employer, then your plan administrator or other designated professional is assigned the responsibility of keeping track of your pretax vs. after-tax assets. For your IRAs, the responsibility rests with you as the owner.

Making Nondeductible Contributions to Traditional IRAs

If a taxpayer does not claim a deduction of their traditional IRA contribution, it is usually because they either are not eligible or simply prefer not to do so. An individual who is eligible for the deduction may decide not to claim it so that their future distributions of the amount are tax- and penalty-free. Regardless of the reason, the taxpayer must file Form 8606 to notify the IRS that the contribution is nondeductible (counting as after-tax assets). To report the after-tax contribution, the individual must complete Part l of Form 8606.

Rolling Over After-Tax Assets to an IRA

One of the things that many people don’t know about IRAs is that they may roll over after-tax assets from their qualified plan accounts to a traditional IRA. According to IRS Publication 590-A: “Form 8606 isn’t used for the year that you make a rollover from a qualified retirement plan to a traditional IRA and the rollover includes nontaxable amounts. In those situations, a Form 8606 is completed for the year you take a distribution from that IRA.” However, it still may be a good idea to complete the form for your records.

Reporting Distributions on Form 8606

Form 8606 should be filed each year when a distribution occurs from a traditional, SEP, or SIMPLE IRA if any of these IRAs hold after-tax amounts. Failure to file Form 8606 could result in the individual paying income tax and an early distribution penalty on amounts that should be tax- and penalty-free. Distributions of after-tax assets are also reported on Part l of the form.

How to Prorate Distributions With After-Tax IRA Contributions

As stated above, if you have after-tax amounts in your traditional IRA, when taking a distribution, you must determine how much of the distribution is attributable to the after-tax amount. You are deemed to have a cost basis equal to the amount of your after-tax contributions. The portion of the distribution that is nontaxable must be prorated with amounts that are taxable.

For instance, an individual contributed $2,000 in after-tax amounts and has a pretax balance (including contributions and earnings) of $8,000 in a traditional IRA, for a total of $10,000. A distribution of $5,000 would be prorated to include $1,000 in after-tax and $4,000 in pretax amounts. This pro rata treatment must continue until all of your cost basis has been distributed.

Aggregate IRAs to Determine Taxable Distributions

To determine the portion of the IRA distribution that is taxable, taxpayers must aggregate all of their traditional, SEP, and SIMPLE IRA balances. This requirement applies even if the after-tax contribution was made to only one IRA. The step-by-step instructions for Part l on the form will help the individual compute the taxable portion of the distribution.

Reporting Roth IRA Conversions on Form 8606

An individual who converts their traditional, SEP, or SIMPLE IRA to a Roth IRA must be able to distinguish between the conversion assets and amounts representing regular Roth IRA contributions and earnings. This distinction is necessary for determining whether any portion of a Roth IRA distribution is subject to income tax and/or penalty. To properly account for these conversion amounts, the individual must complete Part ll on Form 8606.

Tax Implications of Roth IRA Distributions

Part III of Form 8606 is completed to report distributions taken from Roth IRAs. Completing this section allows an individual to determine whether any portion of their Roth IRA distribution is taxable and/or subject to the 10% early distribution penalty if taken prior to age 59½.

Reporting IRA and Roth Conversion Recharacterizations

An individual who recharacterizes a Roth conversion or an IRA contribution must attach a letter (statement) to their tax return explaining the recharacterization. In this letter, you would, for instance, include how much is attributed to the contribution or conversion and the amount attributed to earnings (or indicate if there was a loss on the amount). The verbiage and information included in the statement are determined by whether the individual is recharacterizing from a traditional IRA to a Roth IRA or vice versa, or whether the individual is recharacterizing a Roth conversion. For examples of the information that should be included in the statement, see the instructions for filing Form 8606.

Form 8606 does not have to be filed if the entire contribution or conversion is recharacterized. However, if only part of the contribution or conversion is recharacterized, then the individual must complete Part l of Form 8606. Either way, the statement must be submitted along with the tax return.

Avoiding Penalties When Filing Form 8606

An individual who fails to file Form 8606 to report a nondeductible contribution will owe the IRS a $50 penalty. Additionally, if the nondeductible contribution amount is overstated on the form, a penalty of $100 will apply. In both cases, the penalty may be waived if the taxpayer can show reasonable cause for not complying with the requirements. The IRS typically considers reasonable cause for situations such as death, serious illness, incapacitation, inability to obtain records, natural disaster, or other extreme circumstances. It is always considered on an individual basis based on the specific facts of the situation.

Additional Considerations for Form 8606 Filers

Handling IRA Transfers in a Divorce

Generally, a transfer of IRA assets from one spouse to another is not taxable to either spouse if the transfer is in accordance with the divorce or legal separation agreement. If such a transfer results in a change in the ownership of the after-tax amounts, both spouses must file Form 8606 to show the after-tax amount owned by each. A letter explaining the change should be attached to each spouse’s tax return. It is always a good idea to consult with a financial professional to split retirement accounts in a divorce, to ensure that no tax or early distribution penalties are assessed on the transfer.

Managing Inherited IRAs with After-Tax Contributions

Individuals who inherited IRAs that include after-tax amounts, or “basis,” also must file Form 8606 to claim the nontaxable portion of the distribution. It is important to note that the basis amount in an inherited IRA cannot be combined with any basis in the beneficiary’s regular, non-inherited IRA (i.e., an IRA that the beneficiary established with their own contributions). This rule is one of the exceptions to the other rule that requires all traditional IRA balances to be aggregated (explained above) when calculating the prorated after-tax portion.

For instance, assume that an individual has a traditional IRA that they established and funded, and that this IRA includes only pretax amounts. If this person inherits a traditional IRA that includes after-tax amounts, then their distributions from the inherited IRA would need to be prorated for determining the amounts that are attributable to after-tax assets, and the balance of the beneficiary’s own IRA would not be included in this computation.

On the other hand, let’s assume that the same individual had a traditional IRA that they had established and funded with both pretax and after-tax amounts. They inherit a traditional IRA that also includes after-tax amounts. When they take distributions from the inherited IRA and their own IRA, they will need to file a separate Form 8606 for each account because the basis is calculated separately.

The Bottom Line

You must file Form 8606 for every year you contribute after-tax amounts (nondeductible contributions) to your traditional IRA. Conversions from traditional, SEP, or SIMPLE IRAs also must be reported on Form 8606. Additionally, you must file the form every year when you receive a distribution from your Roth IRA or traditional IRA if you have ever previously contributed after-tax amounts.

Filing this form may provide tax savings, but failure to file may result in paying the IRS tax and penalties on amounts that are meant to be tax- and penalty-free.

If you are not sure whether you are required to file Form 8606, ask your tax advisor. Also, for each year when you file this form, retain copies along with your tax return. These may prove helpful in the future for determining how your transactions were treated for tax purposes.