In part 1 of this series we discuss the filing of Form 5329, which is filed when an individual with a retirement plan or ESA needs to indicate whether he/she owes the IRS the 10% early-distribution or other penalty. In this second part, we give an overview of IRS Form 8606, which has become increasingly important with the introduction of the Roth IRA and more so with the rollover eligibility of after-tax assets from qualified plans.

The taxability of your retirement-account distribution is usually determined by whether the assets are attributable to pre-tax 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 pre-tax versus after-tax assets. For your IRAs, the responsibility rests with you. You must file Form 8606 beginning the first year you contribute after-tax (non-deductible) amounts to your Traditional IRA and every year you receive a distribution from your IRA.

Non-Deductible (After-Tax) IRA Contributions

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
Effective for tax year beginning 2002, individuals may rollover after-tax assets from their qualified plan accounts to their Traditional IRAs. The IRS has not yet indicated whether these amounts should be reported on Form 8606. However, until the IRS provides guidance for reporting assets rolled to an IRA, IRA practitioners suggest reporting the amount in Part l of Form 8606, to ensure proper accounting.

Distributions
Form 8606 must usually be filed each year that a distribution occurs from a Traditional IRA if there was an after-tax contribution made in an earlier year. 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 contributed some after-tax amounts to your Traditional IRA, you must, when taking a distribution, determine whether 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 $8,000 in pre-tax amounts, a distribution of $5,000 would be pro-rated to include $1,000 after-tax and $4,000 in pre-tax 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.

Roth IRA Conversions
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.

Distributions from Roth IRAs
Section lll 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.

Recharacterizations
An individual who recharacterizes a Roth conversion or an IRA contribution must attach to their tax return a letter (statement) 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.

Penalties
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.

Other Considerations

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 a 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/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 an individual has a Traditional IRA that he or she established and funded, and this IRA includes only pre-tax 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.

Conclusion
Now you should have a good understanding of the importance of filing Forms 5329 and 8606. As we have demonstrated, filing them 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 either form, be sure to ask your tax advisor. And, for each year that you file these forms, retain copies along with your tax return. These may prove helpful in the future for determining how your transactions were treated for tax purposes.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.