The Importance Of IRS Form 8606 For Heirs Of IRAs

Here’s a way for saving, potentially, thousands in taxes on IRAs, including on those that you inherit: To get started, learn all about the IRS Form 8606.

This article lays out the purpose of the Form 8606, Nondeductible IRAs, its requirements and benefits as well as the consequences of your failure to file one in a timely manner, including when you inherit retirement funds. It also serves as a reminder to always work with a knowledgeable CPA who can advise you about Form 8606 with the goal of keeping your taxes at a minimum.

Tax Implications For IRA Beneficiaries

“Form 8606 tracks the basis of traditional IRAs whenever there are nondeductible contributions to a traditional IRA,” CPA Larry Pon of Pon & Associates in Redwood City, California, told me. “When taking a distribution from a traditional IRA, the basis, which is in your traditional IRA is the total of nondeductible contributions and the rollover of any after-tax funds from a 401(k) or a 402(b), is not taxable. If this were overlooked or ignored, the beneficiary will be paying taxes on the entire distribution, when only a portion of the distribution may be taxable.”

Using an example provided by Pon, if you are the sole beneficiary of your uncle’s $10,000 IRA, here are the possible scenarios. You find out from your relative’s executor that your uncle did file the Form 8606 covering the IRA, and learn that his basis is $2,000. If you fail to ask the question and assume the entire $10,000 IRA is taxable, then you will be overpaying taxes on the $2,000 basis in the IRA.

If you choose to cash out the fund for the entire amount, your taxable distribution is $8,000. In that case, you must file a Form 8606 indicating the inherited distribution of $8,000. “If you took the entire distribution of $10,000 in one year, the Form 1099R provided by the financial institution will report $10,000 Gross Distribution in Box 1 and $10,000 Taxable Distribution in Box 2,” said Pon. “To correctly show the IRS that only $8,000 is taxable, I suggest including a copy of your uncle’s 8606 from his tax return and a new Form 8606 you completed with the words “Inherited IRA” on top of the document.

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What Is IRS Form 8606?

The IRS Form 8606 is a document that declares to the tax agency your qualified nondeductible contributions to a traditional IRA, a traditional SEP or traditional SIMPLE IRA, an inherited Roth, Roth SEP, or Roth SIMPLE IRA. Its express purpose is to clarify what you do and do not owe in taxes on the retirement accounts mentioned.

According to the consulting firm Wolters Kluwer, some of the applicable situations include “a repayment of a qualified disaster, a qualified reservist or a qualified birth or adoption distribution,” or that you have accepted funds from a traditional, traditional SEP or traditional SIMPLE IRA and the basis is more than zero. Other situations that call for a Form 8606, noted Wolters Kluwers, are that you:

• Received distributions from inherited traditional, traditional SEP, or traditional SIMPLE IRA that has a basis, or receives a distribution from an inherited Roth, Roth SEP or Roth SIMPLE IRA that wasn’t a qualified distribution
• Converted any amount from a traditional, traditional SEP, or traditional SIMPLE IRA to a Roth, Roth SEP or Roth SIMPLE IRA
• Received all or a portion of a traditional SEP or traditional SIMPLE IRA as the result of a divorce or separation agreement, in which the transfer brought a change in the basis of the IRA of either spouse.

If you have questions about whether you need to file a Form 8606 in connection with your retirement funds, consult your accountant.

Why Heirs Of IRAs Should File Form 8606

The IRS lays out why heirs must use Form 8606. They are for:

• Nondeductible contributions you made to traditional IRAs
• Distributions from various retirement accounts, including traditional, SEP or SIMPLE IRAs, if you have made nondeductible contributions to traditional IRAs
• Conversions from an array of retirement accounts, such as traditional, SEP or SIMPLE IRAs to Roth IRAs
• Distributions from Roth IRAs

The most important reason to file a Form 8606 is to clarify your tax picture regarding IRAs and inherited IRAs, so that you don’t end up paying more taxes than you owe.

In addition, if you don’t file the form or give a valid reason for failing to do so, you are subject to a fine. The IRS may also impose a penalty if you overstate your nondeductible contribution.

Often tax professionals are unaware of “nondeductible IRA” contributions, noted Pon, so they fail to include the information on a Form 8606.

“My client’s excuse for not telling me [about nondeductible IRA contributions] is because it makes no difference on the tax return, since it is not deductible,” he added. “ I remind it is important to maintain the accuracy of Form 8606.”

What Happens If A Form 8606 Is Not Filed?

If you don’t file a Form 8606 when warranted, you may end up paying more taxes than you owe. However, there are other consequences.

If your circumstances call for you to file a Form 8606 and you fail to do so or show “reasonable cause” for not complying, you are subject to a $50 penalty. If you overstate your nondeductible contribution on the form, the IRS could assess you with a $100 fine, according to consulting firm Wolters Kluwer.

The IRS states that you must file Form 8606 with your annual income tax return–Form 1040, 1040-SR or 1040-NR by the annual tax deadline, including extensions. If you aren’t required to file an income tax return, then, by the tax deadline, you still must file a Form 8606 separately and include your address and signature on the document.

Bottom Line

Inheriting IRA funds can bring with it taxes owed, as do conversions from a traditional IRA to a Roth. However, the taxes you must pay can be less-taxing–pun intended–if you bone up on IRS Form 8606 and enlist the help of a well-informed CPA. So dig into the subject of Form 8606 and, hopefully, you come up with a rosier tax picture.

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