Retirement Plan Tax Form 8606: When To File

The tax Form 8606 has become increasingly important thanks to the popularity of the Roth IRA and the rollover eligibility of after-tax assets from qualified plans. Basically, you must file Form 8606 for every year you contribute after-tax amounts (non-deductible IRA contribution) to your Traditional IRA, and every year you receive a distribution from your IRA as long as you have after-tax amounts, including rollovers of after-tax amounts from qualified plans,  in any of your traditional, SEP or SIMPLE IRAs. Here we'll look at this tax form and some of the rules surrounding it.

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, then your plan administrator or other designated professional is assigned with the responsibility of keeping track of your pretax versus after-tax assets. For your IRAs, the responsibility rests with you.

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

Rollover of After-Tax Assets from Qualified Plans
One of the things that many people don't know about their IRAs is that they may rollover after-tax assets from their qualified plan accounts to their Traditional IRAs. According to IRS Publication 590: "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. In those situations, a Form 8606 is completed for the year you take a distribution from that IRA." However, it may still be a good idea to complete the form for your records.

Form 8606 must usually be filed each year that a distribution occurs from a Traditional, SEP or SIMPLE IRA if any of your Traditional or SEP 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 also are reported in part l of the form.

Distributions Are Pro-Rated
As we stated above, if you have after-tax amounts in your Traditional IRA, you must, when taking a distribution, determine how much of the distribution is attributable to the after-tax amount. The portion of the distribution that is non-taxable must be pro-rated with amounts that are taxable. For instance, if the individual contributed $2,000 in after-tax amounts and has a pretax balance of $8,000, a distribution of $5,000 would be pro-rated to include $1,000 after-tax and $4,000 in pretax assets. This pro-rata treatment must continue until all the after-tax amounts have been distributed.

IRAs Are Aggregated
To determine the portion of the distribution that is taxable, taxpayers must aggregate all their Traditional, SEP and SIMPLE IRAs 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.

An individual who converts his or her 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 conversions amounts, the individual must complete part ll on Form 8606.

Section 3 is completed to report distributions from Roth IRAs. Completing this section allows an individual to determine whether any portion of his or her Roth IRA distribution is taxable and/or subject to the 10% early-distribution penalty.

An individual who recharacterizes a Roth conversion or an IRA contribution must attach a letter (statement) to his or her 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 information included in the statement is usually 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 is not filed if the entire contribution or conversion is recharacterized. However, if only part of the contribution or conversion is recharacterized, the individual must complete Part l of Form 8606.

An individual who fails to file Form 8606 to report a non-deductible contribution will owe the IRS a $50 penalty. Additionally, if the non-deductible 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.

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.

Inherited IRAs
Individuals who inherited IRAs that include after-tax amounts must also file Form 8606 to claim the non-taxable portion of the distribution. It is important to note that the after-tax amount in an inherited IRA cannot be attributed to a distribution of assets from a regular non-inherited IRA (i.e. an IRA that the beneficiary established with his or her own contributions.) This rule is one of the exceptions to the other rule that requires all Traditional IRA balances to be aggregated (explained above). For instance, assume that an individual has a Traditional IRA that he or she established and funded, and this IRA includes only pretax amounts. If this person inherits a Traditional IRA that includes after-tax amounts, his or her distributions from the inherited IRA would be pro-rated for determining the amounts that are attributable to after-tax assets. The balance of the beneficiary's own IRA would not be included in this computation.

Now you should have a good understanding of the importance of filing Form 8606. As we have demonstrated, filing this form could mean tax savings, while failure to file could result in paying the IRS tax and penalties on amounts that are actually tax- and penalty-free. It is important to note that the information provided here is just a guideline and that each individual's circumstances may require some modification to the general filing requirements. If you are not sure whether you are required to file Form 8606, be sure to ask your tax advisor. And, for each year that 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.