Contributions to a traditional IRA are not always fully tax-deductible. The deduction is phased out for some individuals at certain income levels, resulting in a partial deduction or no deduction. Tax filers who make nondeductible IRA contributions must file an additional tax form to determine how their IRA activity is to be treated for tax purposes.
There is an annual limit on how much someone can contribute to an IRA. However, tax filers who participate in an employer-sponsored retirement plan may have a reduced IRA deduction if their income is at or above certain threshold levels. Subject to even higher thresholds, the spouse of someone who participates in an employer plan may be ineligible to deduct an IRA. Nevertheless, they may contribute to a traditional IRA and defer taxation on the account earnings.
Maintaining a basis
Adequate record-keeping is essential for determining how much of future IRA withdrawals is taxable. Contributions in your IRA that have already been taxed are referred to as your basis. If all your contributions to an IRA are still tax-deferred, your basis is zero. IRA owners sometimes forget financial details over the years, so a specific tax form is required to report most activity occurring in an IRA that contains both pre-tax and after-tax funds.
IRS Form 8606 is required in order to create a record of nondeductible IRA contributions and to determine taxability of distributions. An additional purpose of Form 8606 is to keep track of your basis in IRAs containing after-tax funds. If you make nondeductible contributions, the basis of your IRAs is usually recalculated each year on Form 8606. If necessary, the basis figure is carried over to the following year's Form 8606 to arrive at an updated basis.
Nondeductible aspect of Roth IRAs
A Roth IRA is somewhat similar to a nondeductible IRA, except that Roth earnings are generally tax free when eventually withdrawn. Form 8606 must be used to report Roth IRA distributions. A rollover from a traditional IRA to a Roth IRA is also reported on Form 8606.
If you have no filing requirement for a full tax return, Form 8606 can be filed by itself. The form contains a signature line and is mailed to the same IRS address that receives tax returns for your area.
A single missed Form 8606 can result in miscalculations of basis and of distribution taxability. Failure to file the form when required may result in a penalty. There is also a potential penalty for overstating the amount of after-tax, nondeductible contributions.
Even though Form 8606 keeps track of IRA basis from year to year, you still need to keep the supporting documents until the accounts are fully distributed. Contact an accountant for more advice on retirement planning.