Form 8606: Nondeductible IRAs: What They are, How They Work

What is Form 8606?

Form 8606 is an IRS tax document used to report nondeductible contributions to traditional IRAs and track the basis to prevent double taxation on withdrawals. It also records conversions to Roth IRAs and distributions from both traditional and Roth IRAs, ensuring accurate taxation of your earned income and investment growth.

This form is essential if you make after-tax contributions or engage in Roth conversions, helping you maintain proper tax records over time.

Key Characteristics

Form 8606 has several defining features that help you manage IRA taxation effectively:

• Tracks basis: Records your nondeductible contributions so you don't pay tax twice on the same amount.
• Required filing: Must be filed annually when you make nondeductible contributions or take distributions involving basis.
• Pro-rata rule: Calculates taxable and nontaxable portions of IRA distributions based on total basis.
• Reports Roth conversions: Documents conversions from traditional to Roth IRAs for accurate tax treatment.
• Penalty risk: Failure to file can lead to IRS penalties or full taxation of your basis.

How It Works

When you contribute nondeductible dollars to a traditional IRA, Form 8606 tracks these after-tax amounts as your basis. This tracking prevents the IRS from taxing your contributions again upon withdrawal or conversion.

During distributions or Roth conversions, the form applies the pro-rata rule, dividing taxable and nontaxable amounts based on the ratio of your basis to your total IRA balance. You file Form 8606 each year you have nondeductible contributions or distributions involving basis, attaching it to your Form 1040 tax return.

Examples and Use Cases

Here are common scenarios where Form 8606 is necessary:

• Nondeductible contribution: You contribute $7,000 to a traditional IRA but cannot deduct it due to income limits. You report this on Form 8606 to establish your basis.
• Distribution with basis: If you withdraw $10,000 from a traditional IRA valued at $100,000 with a $20,000 basis, Form 8606 calculates the nontaxable portion to avoid double taxation.
• Roth conversion: Converting $50,000 from a traditional to a Roth IRA requires Form 8606 to report taxable amounts correctly, especially if you have basis in the traditional IRA.
• Investment context: Investors diversifying with funds like BND or exploring best low-cost index funds should track nondeductible contributions carefully to optimize tax outcomes.
• Corporate examples: Employees of major companies like Delta may use Form 8606 when managing IRA contributions alongside employer retirement plans.

Important Considerations

Keep detailed records of all nondeductible contributions as Form 8606 uses this information year over year to calculate your basis accurately. Losing track can lead to overpaying taxes or facing IRS penalties.

If your income exceeds limits for deductible contributions due to a workplace plan, like a 401(k), nondeductible contributions reported on Form 8606 remain a valuable tax planning tool. Understanding backup withholding rules may also be relevant if distributions are involved.