Form 8606

DEFINITION of 'Form 8606'

Form 8606 is a tax form distributed by the Internal Revenue Service (IRS) and used by filers who make nondeductible contributions to an IRA. A separate form should be filed for each tax year that nondeductible contributions are made. Normally, contributions to an Individual Retirement Account (IRA) are deductible from ordinary income. However, under certain circumstances, people who participate in an employer retirement plan and whose households have over a certain modified adjusted gross income (MAGI) might not be able to make these deductible contributions. They can still contribute to an IRA; it just won't reduce their ordinary income.

Form 8606 is also required whenever: 1) a taxpayer converts a Traditional or SEP IRA into a Roth IRA, or 2) receives an IRA distribution that is attributable to previous nondeductible contributions. If 8606 is not filed in a distribution year, the taxpayer is likely to be forced to pay income taxes (and possibly penalties) on what could be tax-free monies.

BREAKING DOWN 'Form 8606'

Form 8606 should be filed in conjunction with the standard income tax forms (1040, 1040A, or 1040NR) for individual filers. Any taxpayer with a cost basis above zero for IRA assets (a combination of post-tax and pretax contributions, or deductible and nondeductible contributions) should use Form 8606 to prorate the taxable vs. nontaxable distribution amounts.

Younger investors should consider "recharacterizing" Traditional and SEP IRA assets as Roth assets. Assets that are recharacterized from a Traditional or SEP IRA into a Roth IRA are immediately taxable as ordinary income. This is because the money placed into a Traditional IRA or SEP IRA has usually never been taxed. When money comes out of a Traditional or SEP IRA, it becomes taxable. Roth IRAs are full of money that has already been taxed. Already taxed money goes into the account, it gets invested and grows. The money is not taxed when it comes out of the account. The immediate tax bill caused by the recharacterization may be outweighed over time by not having to pay taxes on future distributions, which should theoretically have more value due to inflation. People should speak with a tax professional before attempting a recharacterization.