What You Need to Know About Form 8606 (and Other IRA Tax Rules)

Even if you’ve been paying taxes for decades, you’ve probably only ever encountered a fraction of the tax forms made available by the IRS. Form 8606 is one that may be familiar only to certain taxpayers with IRAs. This form has a few specific purposes, all of which relate to reporting actions you take around your IRA. Whether or not you’ve used Form 8606 before, if you have an IRA you may need to file it this year. 

What is IRS Form 8606?

Form 8606 is required for anyone who makes nondeductible contributions to a traditional IRA. 

Many IRA contributions are tax-deductible; the ability to deduct your contributions from your taxes is one of the reasons people use these accounts. Per the IRS’s contribution limits, for 2021 you’re allowed to contribute up to $6,000 ($7,000 for people 50+) to your IRAs. If you’re not covered by a retirement plan at work, and you don’t have a spouse who is covered by a retirement plan at work, you can generally deduct the full amount of your contributions from your taxes. 

However, if you and/or your spouse are covered by a retirement plan at work, your modified AGI determines how much of your IRA contributions you’re allowed to deduct. If your income is above a certain level, you may be allowed to take a partial deduction or no deduction at all. If you still choose to add money to your IRA, you would report those nondeductible contributions using Form 8606.

Form 8606 is also used for reporting other kinds of actions around IRAs, so you may still need to use this form even if you didn’t make any nondeductible contributions during a given tax year. If you take distributions from a traditional, SEP or SIMPLE IRA and you’ve made nondeductible contributions to a traditional IRA in the past, you’ll have to file this form. 

The surging popularity of Roth IRAs means that many taxpayers who are new to this kind of account will have to file Form 8606. It’s required after any tax year in which you take distributions from a Roth IRA. If you convert part or all of a traditional, SEP or SIMPLE IRA to a Roth IRA, you’ll also need to report this via Form 8606.

Finally, a taxpayer may also need to file Form 8606 if they transfer an IRA to a spouse as part of divorce proceedings, or if they take distributions that meet certain conditions from an inherited IRA. 

What Should I Need to Know About Form 8606?

If you’ve made any nondeductible contributions during a given year, or have taken any other action that requires you to complete Form 8606, you’ll generally file this form with your income tax return. Your spouse may need to file their own Form 8606 in certain circumstances; speak to your advisor for specific guidance.

If you’re required to file Form 8606 but either don’t submit it or provide incorrect information, the IRS imposes a $50 penalty for failing to file. This fee may be waived if you can show good reason for not having filed on time. Overstating your nondeductible contributions will incur a $100 penalty. 

What Else Should I Know?

Anyone who has at least one IRA should be aware of the tax responsibilities around these accounts. There are a few key rules we suggest you keep in mind. 

• Coronavirus-related distributions have special tax rules. If you withdrew money from an IRA because of the COVID crisis, you’ll have to account for those penalty-free distributions on your taxes. There were a lot of ways to take advantage of this CARES Act provision, so there’s not one straightforward way for everyone to report these actions. We recommend working with your advisors to determine what forms you need to file this year.
• Watch your contribution limits. Adding too much money to your IRA can backfire come tax time. The IRS imposes a 6% tax on any contributions in excess of your yearly contribution limit (again, $6,000 for 2021 or $7,000 for people 50+).
• Know the UBTI consequences. If you use your IRA to make certain kinds of investments, the account may earn unrelated business taxable income. Any UBTI your IRA earns in excess of $1,000 will be taxed and has to be reported to the IRS using Form 990-T. This won’t be relevant to many IRA account holders.
• Don’t guess. This may be the most important piece of advice we can impart about IRA tax rules. They can be confusing even to taxpayers who have had their IRAs for years. If you’re not sure whether your IRA earns UBTI or how to complete Form 8606, it’s far preferable to get professional help upfront than to guess and risk a penalty later on. Making a single mistake can also entangle you in a long and frustrating back-and-forth with the IRS. Getting this right the first time is certainly easier. 

What questions do you have about Form 8606, or about other IRA tax rules that might affect you this year? At Sachetta Callahan, we work with clients to help them understand their specific tax obligations and to make tax time as simple and low-stress as possible. Contact me today.

Michael J Callahan, CPA, CFP®, MST, Partner, Director- Wealth Management is a Certified Financial Planner™ practitioner, Certified Public Accountant, and holds a Master’s Degree in Taxation from Bentley University. Mike has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years.