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Retirement Perspectives

Be sure to carefully track and report your IRA accounts’ basis.

With tax season approaching, IRS Form 8606, “Nondeductible IRAs,” should be required reading for all financial advisors and their clients. That’s because it is the most important—and frequently overlooked—document governing the taxation of IRAs. Overlooking that document and its purpose could result in retirement investors paying taxes on previously taxed retirement savings.

Nondeductible, or aftertax, contributions to IRAs first began in 1987. Since then, the importance of Form 8606 has grown along with the popularity of traditional IRAs, Roth IRAs, Roth conversions, “back-door” Roth strategy, and the (subsequent) ability to roll over aftertax (non-Roth) assets from qualified plans.

Form 8606, which is filed along with an individuals’ tax return, serves to, among other things, report and track an IRA account owners’ basis. If the form is not filed on time (an all too common occurrence), the IRS will not be aware that some or all of an individual’s IRA consists of aftertax dollars.  Without that knowledge, the IRS could expect to collect taxes on funds being distributed.

Essentially, taxpayers must file Form 8606 if they have contributed aftertax amounts to their traditional IRA, or have taken a distribution from a traditional, SEP, or SIMPLE IRA that contains basis (e.g., aftertax dollars). Moreover, filing is required upon taking a distribution from a Roth IRA, as well as conversions from traditional, SEP or SIMPLE IRAs to Roth IRAs, as well as when individuals roll over aftertax dollars from employer-sponsored plans, such as 401(k)s, to an IRA. However, while assets are invested in a 401(k) or other qualified plan, the plan administrator or recordkeeper is responsible for keeping track of a participant’s basis. That is not the case with an IRA, where tracking the basis is up to the account owner.

Here are few frequently asked questions:

What is the purpose of Form 8606?
It is used to report the following transactions:

  • Nondeductible traditional IRA contributions;
  • Traditional, SEP, or SIMPLE IRA distributions that contain nondeductible contributions;
  • Roth IRA conversions from traditional, SEP or SIMPLE IRAs to Roth IRAs; or
  • Distributions from Roth IRAs.

Who should file Form 8606?
File Form 8606 for any year in which one or more of the following transactions occur:

  • Nondeductible contributions are made to a traditional IRA;
  • Distributions from a traditional IRA, SEP, or SIMPLE IRA that contain nondeductible dollars;
  • Roth IRA conversion from a traditional, SEP or SIMPLE IRA;
  • Distributions from a Roth IRA; 
  • You received a distribution from an inherited traditional IRA that contains basis; or
  • You received a non-qualified distribution from an inherited Roth IRA.

Are there any penalties for failing to file Form 8606?
Form 8606’s instructions state that unless an individual can show reasonable cause, there is a $50 penalty for each year it was not filed. In addition, there is a $100 penalty for overstating the amount of the nondeductible contributions.

Where can additional information on filing Form 8606 be found?
See here.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

Backdoor Roth IRA.  Since 2010, high-income earners have been eligible to convert traditional IRA assets to Roth IRAs. This is accomplished by making nondeductible (aftertax) contributions to a traditional IRA and converting the assets to a Roth sometime thereafter.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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