Filing taxes can be complicated, especially when it comes to nondeductible IRAs. Many taxpayers likely find Form 8606 confusing and struggle to determine when and how to file it properly.
Luckily, this guide will provide a thorough overview of Form 8606, explaining exactly what it is, who needs to file it, how to report nondeductible contributions, and more. You'll learn the key rules around nondeductible IRAs and inherited IRAs so you can confidently file Form 8606 and avoid penalties.
We'll cover topics like the difference between deductible and nondeductible IRAs, the ordering rules for distributions, how to calculate your taxable distribution amount, filing requirements for inherited IRAs, and reporting rules for Coverdell ESAs. Whether you need to file for a nondeductible IRA, inherited IRA, or Coverdell ESA, you'll have the necessary knowledge after reading this guide.
Introduction to Form 8606 and Nondeductible IRAs
Form 8606 is an IRS tax form used to report nondeductible contributions made to traditional IRAs and to track the nondeductible basis. You must file Form 8606 when you make nondeductible contributions to a traditional IRA or if you take a distribution from a traditional IRA that includes nondeductible contributions.
What is Form 8606?
Form 8606 is an IRS tax form used to report nondeductible contributions made to traditional IRAs. It tracks the nondeductible basis, which is the cumulative amount of nondeductible contributions made over the years. This allows the IRS to determine the taxable portion of any distributions from IRAs that hold both deductible and nondeductible amounts.
When is Form 8606 Required?
You must file Form 8606 for any year in which you make nondeductible contributions to a traditional IRA. This includes:
- The year you first make a nondeductible contribution
- Any subsequent year in which you make additional nondeductible contributions
- Any year you take a distribution from any traditional IRA if you have ever made nondeductible contributions
This allows the IRS to track your nondeductible basis.
You must also file Form 8606 if you inherit a traditional IRA that includes nondeductible contributions made by the original owner.
Understanding Deductible and Nondeductible IRA Contributions
Deductible IRA contributions allow you to take a tax deduction for the contribution amount in the year you make it. Nondeductible IRA contributions do not provide a tax deduction, but allow the money to grow tax-deferred.
For deductible IRAs, distributions in retirement are taxed at ordinary income tax rates. For nondeductible IRAs, only the earnings portion of distributions is taxed - the contributions were already taxed upfront.
There are income limits that can impact whether you can make deductible IRA contributions. If your income exceeds a certain threshold, your ability to deduct contributions is reduced or eliminated. In that case, you can make nondeductible contributions instead to still benefit from tax-deferred growth.
Overview of Nondeductible IRAs
A nondeductible IRA is a traditional IRA to which you make contributions for which you do not take a tax deduction. The contributions are made with after-tax dollars but still benefit from tax-deferred growth once inside the IRA.
The key advantage of a nondeductible IRA over a taxable investment account is that earnings grow tax-deferred rather than annually taxed. This allows more compound growth over long time periods.
Distributions from nondeductible IRAs are only taxed on the portion attributable to earnings, not contributions. By tracking your nondeductible basis via Form 8606 each year, you avoid double taxation on the contributions portion later on.
The Role of Internal Revenue Code Section 408
Internal Revenue Code Section 408 contains the rules that govern IRAs, including both deductible and nondeductible IRAs. It defines important aspects such as:
- Contribution limits
- Tax treatment of distributions
- Rollover rules
- Required minimum distributions
- Prohibited transactions
Section 408(o) specifically covers the tax treatment of nondeductible IRA contributions and distributions. It is what requires the use of Form 8606 to track basis and determine the taxable portion of later distributions.
So in essence, IRC Section 408 provides the overall framework for the tax treatment of IRAs, while subsection 408(o) focuses specifically on nondeductible IRAs.
What is Form 8606 not used for?
According to IRS Publication 590-A, Form 8606 is not used for the year that you make a rollover from a qualified retirement plan to a traditional IRA and the rollover includes nontaxable amounts.
Some key points about what Form 8606 is not used for:
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Rolling over nontaxable amounts from a qualified retirement plan to a traditional IRA. This includes rollovers of after-tax contributions from a 401(k) or other workplace retirement plan. These nontaxable rollovers do not require Form 8606 reporting.
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Converting from a traditional IRA to a Roth IRA. Form 8606 is used to report conversions from traditional IRAs to Roth IRAs, but is not required simply for making annual Roth IRA contributions.
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Reporting deductible IRA contributions. Form 8606 tracks basis in IRAs due to nondeductible contributions. It does not report routine deductible IRA contributions claimed on Form 1040.
So in summary, while Form 8606 has some key IRA reporting duties, it is not required for certain transactions like deductible contributions or Roth conversions. Its main purpose is tracking basis for distributions from IRAs with both deductible and nondeductible amounts.
What happens if you forgot to file Form 8606 for nondeductible IRAs?
If you are required to file Form 8606 to report a nondeductible contribution to a traditional IRA for 2022, but failed to do so, you may face a $50 penalty for late filing, unless you can demonstrate reasonable cause for missing the deadline.
The IRS requires taxpayers to file Form 8606 to track the basis of nondeductible contributions made to a traditional IRA. This allows the IRS to determine the taxable portion of future distributions from the IRA. Without filing this form, the entire distribution could be taxed when funds are withdrawn in retirement.
Some situations where you may need to file Form 8606 for a nondeductible IRA contribution include:
- You made after-tax contributions to a traditional IRA
- You made a rollover from an employer plan to a traditional IRA that included after-tax contributions
- You converted part, but not all, of your traditional IRA to a Roth IRA
- You received a distribution from an IRA that included nondeductible contributions
If you failed to file Form 8606 to report any nondeductible traditional IRA contributions for 2022, here is what you need to know:
- You will owe a $50 late filing penalty when you finally file, unless you have reasonable cause for missing the deadline and can demonstrate that to the IRS. Examples of reasonable cause include destruction of records by natural disaster, serious illness, or death of a close family member.
- You must file Form 8606 with your annual tax return for the year you made the nondeductible contribution(s) to your traditional IRA. So if you made a contribution for 2022, you need to file Form 8606 with your 2022 taxes, even if you already filed your return. You would need to amend your 2022 tax return to include the missing Form 8606.
- In addition to the $50 penalty, you may owe additional taxes on the nondeductible contribution or any earnings if you wait too long to file Form 8606 and amend previously filed tax returns.
The bottom line is that if you failed to properly track nondeductible IRA contributions, you should file Form 8606 and amend previous tax returns as soon as possible. This will allow you to minimize any penalties and additional taxes owed. Reach out to a tax professional if you need help getting back in compliance with the IRS requirements.
Who completes Form 8606?
Form 8606 is used to report nondeductible contributions made to traditional IRAs and to calculate the taxable portion of distributions from IRAs when withdrawals contain both deductible and nondeductible amounts.
You must file Form 8606 if any of the following apply:
- You made nondeductible contributions to a traditional IRA for the current tax year or previous tax years
- You took a distribution from a traditional, SEP, or SIMPLE IRA and you have ever made nondeductible contributions to a traditional IRA
- You converted amounts from a traditional, SEP, or SIMPLE IRA to a Roth IRA
So in summary, if you have made nondeductible contributions to a traditional IRA, or if you have taken distributions from an IRA that contained both deductible and nondeductible amounts, you generally need to complete Form 8606 to calculate the taxable portion. This includes people who have inherited an IRA that contains nondeductible contributions.
Consult the instructions for Form 8606 for more details on specific situations where the form may need to be filed. Tracking nondeductible contributions and taxable distributions can be complex, so working with a tax professional may be advisable if you need to complete this form.
Do you include inherited IRA on Form 8606?
Inherited IRAs keep their original basis (assumed $0 by default, unless the decedent had a Form 8606 on file), and must be calculated on a separate Form 8606 from your own IRAs (and inherited IRAs from different people). The one exception is if the inherited IRA is from your spouse and you elect to treat it as your own IRA.
When you inherit an IRA, you have a few options:
- Take lump-sum distribution: The entire IRA balance is taxed as ordinary income in the year distributed with no 10% penalty.
- Take distributions over 5 years: Each distribution is taxed as ordinary income with no 10% penalty. Must empty IRA by end of 5th year.
- Take lifetime RMDs: You take annual required minimum distributions (RMDs) based on your life expectancy. Distributions are taxed as ordinary income. No 10% penalty if you take the RMD amount.
If you take lump-sum or 5-year distributions, you do not need to file Form 8606. The inherited IRA is closed so there are no nondeductible basis tracking requirements.
However, if you take lifetime RMDs, you must file a separate Form 8606 each year to track the nondeductible basis of that specific inherited IRA. The inherited IRA keeps the same basis as the original IRA owner had.
So in summary, yes you must track an inherited IRA separately on Form 8606 if taking lifetime RMDs. The exception again is a spouse electing to treat the inherited IRA as their own. In that case, they would report it on their existing Form 8606 that tracks their own IRAs.
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Reporting Nondeductible Contributions on Form 8606
Form 8606 is used to report nondeductible contributions made to traditional IRAs. Understanding the rules around nondeductible IRA contributions and properly filing Form 8606 is important to avoid paying unnecessary taxes on IRA withdrawals in retirement.
Determining Your Nondeductible Contribution Limit
The amount you can contribute to a traditional IRA as a nondeductible contribution depends on your income and whether you or your spouse actively participates in an employer-sponsored retirement plan:
- If neither you nor your spouse is covered by a retirement plan at work, you can make a full nondeductible contribution up to the annual IRA contribution limit ($6,000 in 2022, or $7,000 if age 50 or older).
- If you or your spouse is covered by a work retirement plan, your ability to make nondeductible contributions phases out at higher income levels based on IRS guidelines.
Consult IRS Publication 590-A for specific income thresholds that determine your eligibility to make nondeductible IRA contributions.
Instructions for Completing Form 8606
You must file Form 8606 for any year you make a nondeductible IRA contribution, take a distribution from your IRA, or have a balance in your traditional IRAs that includes basis from nondeductible contributions. Here are key steps:
- Part I: Report your nondeductible contributions for the year.
- Part II: Calculate the amount of any IRA distributions that will be tax-free based on your nondeductible contribution basis.
- Part III: Figure your total IRA basis for next year after accounting for this year's activity.
Attach the completed Form 8606 to your Form 1040 tax return for the year. Keep records showing you designated the contributions as nondeductible when made.
Failing to File Form 8606
If you fail to file Form 8606 to report nondeductible IRA contributions, the IRS will treat your entire IRA balance as deductible contributions and earnings. This means the nondeductible portion will be taxed twice — when contributed and later when withdrawn in retirement.
To correct the issue, you can file past year Form 8606 returns along with an amended tax return (Form 1040-X). You may have to pay penalties for failing to properly report nondeductible IRA contributions.
All Form 8606 Revisions and Updates
It's important to use the most current version of Form 8606 each year to properly track your nondeductible IRA basis. Major changes to Form 8606 over the years include:
- 2010: Added Part III to calculate total IRA basis for next year.
- 2014: Combined and simplified Parts I and II.
- 2018: Reflected changes due to new tax law.
Consult the form instructions each year for the latest guidelines on reporting nondeductible IRA contributions.
Non Deductible IRA Distribution Taxation
Ordering Rules for Distributions
The IRS has specific ordering rules that dictate which portion of an IRA distribution gets taxed first from a nondeductible IRA. First, any nondeductible contributions are considered to come out tax-free. After all nondeductible contributions have been withdrawn tax-free, any remaining amounts distributed are considered earnings and deductible contributions, which would be subject to income tax and potential early withdrawal penalties.
So in essence, nondeductible contributions come out first tax-free until fully recovered, then deductible contributions and earnings come out and get taxed as ordinary income.
Calculating Partially Taxable Distributions
When taking a distribution from a nondeductible IRA that contains both nondeductible basis and taxable earnings/deductible contributions, it's necessary to calculate the taxable portion.
Here is the process:
- Calculate the ratio of nondeductible basis to total IRA balances across all your IRAs at the end of the year (including SEP and SIMPLE IRAs).
- Apply this ratio to the amount of the distribution.
- The resulting figure represents your non-taxable basis amount recovered.
- Subtract this non-taxable portion from the total distribution amount to determine how much gets taxed as ordinary income.
For example, if you had $6,000 of nondeductible basis in your IRAs, and $12,000 total across all IRAs, your basis ratio would be 50% ($6,000 / $12,000). If you took a $3,000 distribution, then $1,500 would be non-taxable basis recovery (50% of $3,000), and the remaining $1,500 would be taxable as income.
You must file Form 8606 each year you take IRA distributions to calculate the taxable amount or report nondeductible contributions.
Understanding Fully Taxable Distributions
Once your cumulative nondeductible IRA contributions have been fully withdrawn tax-free over time, any remaining distributions are fully taxable as ordinary income, similar to deductible Traditional IRA withdrawals. Applicable early withdrawal penalties may also apply if taken before age 59 1/2.
So in summary, nondeductible IRAs provide tax-free basis recovery, followed by taxable income treatment on remaining balances. Form 8606 tracks this over time.
Inherited Non Deductible IRA: Rules and Taxation
Inheriting a nondeductible IRA can be complicated due to special rules regarding required minimum distributions (RMDs) and determining the taxable basis.
Determining Basis in an Inherited IRA
When inheriting a nondeductible IRA, the beneficiary must redetermine the basis. This involves dividing the deceased IRA owner's remaining nondeductible contributions by the account balance at the date of death. This ratio represents the non-taxable percentage of future distributions.
For example, if the deceased made $100,000 in nondeductible contributions over the years and the IRA balance was $250,000 at death, the non-taxable basis would be $100,000/$250,000 = 40%.
Reporting Inherited IRA Distributions
Beneficiaries must continue filing Form 8606 for any distributions taken from an inherited nondeductible IRA. This form tracks the non-taxable basis over time. If distributions exceed the available nondeductible basis, the excess is taxed as ordinary income.
RMD Rules for Inherited IRAs
The required beginning date and distribution period for RMDs differs depending on if the beneficiary is a spouse or non-spouse. Spousal beneficiaries can roll over the IRA into their own name and follow standard RMD rules.
For non-spouse beneficiaries, RMDs must begin by December 31st of the year following the original owner's death. The distribution period also depends on whether the beneficiary is an eligible designated beneficiary. The non-taxable basis percentage carries over to determine what portion of RMDs is tax-free.
Careful recordkeeping and basis tracking is essential when inheriting a nondeductible IRA in order to properly report distributions and associated taxes.
Coverdell Education Savings Accounts (ESAs)
Introduction to Coverdell ESAs
Coverdell Education Savings Accounts (ESAs) are tax-advantaged investment accounts used to save for education expenses. They allow after-tax contributions to grow tax-deferred and can be used tax-free for qualified education expenses including tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution.
Coverdell ESAs allow total annual contributions of up to $2,000 per beneficiary from all contributors. The ability to contribute phases out for individuals with modified adjusted gross income between $95,000-$110,000 ($190,000-$220,000 for married filing jointly). The beneficiary must be under age 18 at the time of contribution, or a special needs beneficiary.
Tax Benefits and Limitations of Coverdell ESAs
The key benefits of Coverdell ESAs include:
- Tax-deferred growth on contributions
- Tax-free withdrawals for qualified education expenses
- Ability to change beneficiaries
- Variety of investment options
However, there are limitations:
- Low annual contribution limits compared to 529 plans
- Income phase-out limits for contributors
- Beneficiary must use funds before age 30 (with some exceptions)
So while Coverdell ESAs provide some tax advantages, 529 plans may allow greater flexibility and contribution room for many families.
Filing Form 8606 for Coverdell ESAs
Form 8606, Nondeductible IRAs, is used to report nondeductible contributions made to traditional IRAs and any distributions taken from IRAs or qualified retirement plans that have basis. This form helps calculate the taxable portion of IRA distributions.
For Coverdell ESAs, Form 8606 is filed if:
- There is a rollover from one Coverdell ESA to another
- There is a return of excess contributions plus earnings
- Distributions are taken from an ESA for non-qualified expenses
In these cases, Form 8606 tracks the basis to determine taxable earnings. This helps properly calculate taxes owed on distributions not used for qualifying education expenses before age 30.
Additional Resources and References
About Publication 575: Pension and Annuity Income
Publication 575 from the IRS provides detailed guidance on the tax treatment of pension and annuity income. This includes rules around IRA distributions, which are relevant when filling out Form 8606 for nondeductible IRAs. Key details in Publication 575 related to Form 8606 include:
- Overview of how IRA distributions are taxed
- Explanations of deductible and nondeductible IRA contributions
- Instructions on determining the taxable portion of IRA distributions
- Examples and calculations for filling out Form 8606
Reviewing Publication 575 can supplement what you learn from the instructions for Form 8606.
Understanding Form 1040 and its Connection to Form 8606
Form 1040 is the main U.S. individual tax return form. Several lines on Form 1040 relate to reporting IRA contributions and distributions. This reporting works hand-in-hand with Form 8606. Key connections include:
- Line 15a and 15b for deductible IRA contributions
- Line 20a and 20b for nondeductible IRA contributions
- Line 4a and 4b for IRA distributions
The amounts reported on Form 1040 should match what you report on Form 8606 when computing taxable IRA distributions. Form 8606 then carries over the calculated taxable amount to Form 1040.
Consult a Tax Professional
The rules around nondeductible IRAs and properly tracking basis can be complex. Consider working with a qualified tax preparer or CPA each year you file Form 8606. An experienced professional can ensure you complete the form accurately based on your personal situation.
Summary of Main Points
Key takeaways regarding Form 8606 and taxation of nondeductible IRAs and Coverdell ESAs:
- Track nondeductible contributions to determine basis
- Compute the taxable portion of any distributions
- Report nondeductible amounts on Form 8606 every year
- Get professional help to avoid mistakes
Refer to the IRS instructions for Form 8606 and Publication 575 for more specifics.
