Using Form 8606 can protect your retirement funds from any fees and penalties that can cut into it. Keep reading to learn more about this IRS form here.
In this article:
- What Is Tax Form 8606?
- Who Needs to Use This Form?
- Why Should I Use the Nondeductible Form?
- What Happens If I Sent in the Form Even If I Didn’t Have To?
- IRS Form 8606 Instructions: How Do I Fill out This Form?
Tax Forms 101: IRS Form 8606 for Nondeductible IRAs
What Is Tax Form 8606?
Investors who contribute to an individual retirement account (IRA) that doesn’t have deductible contributions still needs to report the contribution in their tax return. To do this, they should use Tax Form 8606 for Nondeductible IRA to support them when they file their income tax.
Investors who don’t report their contribution in their income tax return may face penalties, or worse, an audit from the IRS. Specifically, a non-filing fee of at least $50 applies, and can also put the investor in a bad light with the Internal Revenue Service (IRS).
How can this affect you during retirement? Any additional penalties from the IRS will lower your chances of reaching your retirement nest egg.
Remember, the usual investors who use form 8606 are those who contribute beyond the Traditional or Roth IRA limits. Investors consider these as last resort IRAs, since these retirement accounts:
- Have specific investment goals
- Are a recharacterization of funds, basically the possibility of a rollover of funds from an account to another
- Grow tax-deferred
- Won’t show up as a tax-deductible
Again, only use Form 8606 for contributions to a nondeductible retirement account. All contributions in this form don’t affect your taxable income.
Who Needs to Use This Form?
Investors only have one reason to use Form 8606: to report contributions that are nondeductible.
Financial actions that require filing this form include:
- Recharacterization, also known as the transfer or conversion of a Traditional, SEP or SIMPLE IRA into a Roth IRA
- Taking a distribution from a Roth IRA
- Receiving a distribution from a Traditional, SEP, or SIMPLE IRA if you made a nondeductible distribution from a Traditional IRA
- Making a nondeductible contribution to a Traditional IRA
Sometimes, an employer or other entity will give you Traditional IRA contributions which put you at the limits. You can then make contributions to other accounts to make your retirement goals easier to reach.
Roth IRAs receive contributions already taxed, which means you already paid taxes on them.
A SEP IRA refers to the simplified employee pension. Usually, small business owners and self-employed freelancers use a SEP IRA with their own individual retirement account.
On the other hand, a SIMPLE IRA, or Savings Incentive Match Plan for Employees Individual Retirement Account, is a retirement account employers can use to compensate employees.
Each of these retirement accounts has its own pros and cons.
For example, a SIMPLE IRA has lower administration fees but has stricter guidelines. SIMPLE and SEP IRAs may also have lower contributions limits.
A Roth IRA receives contributions already taxed. That means the withdrawal, while technically income, can’t be considered as a deductible that can lower your Adjusted Gross Income.
What is Adjusted Gross Income? Adjusted Gross Income is the sum of the total gross income subtracted by specific deductions. These specific tax deductions can be seen above the line, and your AGI can significantly affect your tax income bracket and applicable tax rate.
Why Should I Use the Nondeductible Form?
The IRS may see investors who don’t file their contributions to a nondeductible retirement plan as a red flag. An audit from the IRS can happen and penalties may be imposed if there are inaccuracies or mistakes in your returns.
Another thing to remember: contributions to these IRAs grow with time. If you’re expecting a higher tax bracket upon retirement, funding an IRA with after-tax dollars can help you save income since you don’t pay additional taxes on the basis (original capital that has already been taxed).
In fact, some retirees can still give contributions to retirement plans since the required minimum distributions start at 70 and ½ years old. This often unknown and efficient use of contributions form part of the investment strategies on why the rich get richer, and what normal investors can do to improve their practical money skills.
What Happens If I Sent in the Form Even If I Didn’t Have To?
Sending Form 8606 when you don’t need to incurs a penalty from the IRS for inaccuracy. If you’re not certain, please talk to a financial adviser for other possible investment options, or a tax professional to ensure you’re filing your taxes properly and accurately.
IRS Form 8606 Instructions: How Do I Fill out This Form?
Form 8606 only has two pages with 25 sections. The filing form mainly has three parts.
The first four lines, which aren’t part of the three parts, will ask for personal information, specifically the taxpayer’s name, Social Security number, and address.
If you’re sending the form 8606 with your tax return, you don’t need to enter your address. However, Form 8606 still requires your name and Social Security number.
Part 1 will refer to contributions that aren’t tax-deductible. Here’s what you need to provide in this part:
- 1st Line Nondeductible contributions to a Traditional IRA, even for those outside the tax year but inside the calendar year before the tax deadline
- 2nd Line: Total basis in all traditional IRAs
- 3rd Line: Sum of lines 1 and 2
- 4th Line: Contributions outside the tax year but before the tax deadline. Specifically, these are the contributions from January to April of the calendar year.
- 5th Line: The amount when you subtract line 3 with line 4
- Lines 6-15: Contributions from A SEP, SIMPLE and Traditional IRAs. These lines may seem complex, but they’re only asking for the nontaxable amounts, the total basis for all IRAs and other important information.
Parts 2 and 3
For Part 2, lines 16 to 18 will ask for information regarding recharacterizations or transfers from Traditional, SEP or SIMPLE IRAs to Roth IRAs.
Lastly, Part 3, lines 19 to 25, will ask about any distributions from Roth IRAs. Since these amounts are technically income and have already been taxed, Roth withdrawals are not taxable deductions.
The second to the last lines will ask for your signature and date signed. The last box is only applicable if you’re a paid tax preparer.
The IRS can amend, change or even cancel any forms. It’s in your best interest to look at the IRS website first before printing any forms, as the IRS will have the updated and correct tax form.
Having nondeductible contributions can help you reach your retirement goals earlier since the contributions usually mean you’ve already reached the contribution limits for your IRAs. Just remember to always answer and submit the appropriate filing form to avoid any issues with the IRS.
Do you have any questions about Form 8606? Any clarifications for the nondeductible contributions? Let us know in the comments section below.
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