Nondeductible IRA Basis: How Form 8606 Can Prevent You From Paying Tax Twice
Making a nondeductible contribution to a traditional IRA can create an important tax attribute that may remain relevant for decades. That attribute is basis in your traditional IRAs. If the basis is properly documented, part of a future traditional IRA distribution or Roth conversion may be excluded from taxable income because that portion represents money that has already been taxed.
The problem is that IRA basis may not be apparent from an investment statement. Years may pass between the original contribution and the distribution or conversion that ultimately recovers the basis. Accounts may move between financial institutions, taxpayers may change tax preparers, and old tax returns may be discarded. When the records disappear, establishing the amount of previously taxed money in traditional IRAs can become difficult.
For taxpayers who have made nondeductible traditional IRA contributions, Form 8606 is therefore an important continuing tax record. It documents nondeductible contributions and helps determine the remaining basis available to reduce the taxable portion of future traditional IRA distributions and Roth conversions.
What Is IRA Basis?
A traditional IRA can contain both amounts that have not yet been taxed and amounts that have already been taxed. Deductible IRA contributions and earnings generally have not yet been included in taxable income. A nondeductible contribution, by contrast, is a contribution for which no income tax deduction is taken.
Nondeductible contributions create basis. The Instructions for Form 8606 define basis in traditional IRAs as the total of nondeductible contributions and certain nontaxable amounts included in rollovers to traditional IRAs, reduced by amounts of basis that have already been recovered through nontaxable distributions and subject to other applicable adjustments.
Form 8606 Documents Nondeductible Contributions
Internal Revenue Code Section 408(o) permits designated nondeductible contributions to an individual retirement plan and establishes reporting requirements for those contributions and related IRA information.
A taxpayer who makes a nondeductible contribution to a traditional IRA for a tax year is required to file Form 8606 for that year. Form 8606 is also used to report traditional IRA distributions when basis is present, conversions from traditional IRAs to Roth IRAs, and certain Roth IRA distributions.
When a taxpayer has remaining traditional IRA basis from an earlier year, Form 8606 generally uses that prior basis in calculating the current year's remaining basis and the taxable and nontaxable portions of applicable distributions or conversions. Preserving prior Forms 8606 is therefore essential.
Married taxpayers also need to remember that IRA basis is determined separately for each IRA owner. If both spouses are required to file Form 8606, the IRS instructions require a separate Form 8606 for each spouse. Filing a joint income tax return does not combine the spouses' IRA basis.
You Generally Cannot Select Only the After Tax Money for a Roth Conversion
Internal Revenue Code Section 408(d)(2) contains an aggregation rule for determining the taxable and nontaxable portions of traditional IRA distributions. Under that rule, applicable individual retirement plans are treated as one contract and distributions during the taxable year are generally treated as one distribution for purposes of applying Section 72.
For an ordinary traditional IRA distribution or Roth conversion subject to the Form 8606 calculation, this generally prevents a taxpayer from placing nondeductible contributions in one traditional IRA, maintaining pretax money in another traditional IRA, and then treating a distribution or conversion from the first account as consisting solely of after tax money.
For purposes of Form 8606, the term traditional IRA generally includes traditional SEP IRAs and traditional SIMPLE IRAs. Accordingly, pretax balances in those accounts can affect the taxable portion of a Roth conversion even when the conversion is made from a different traditional IRA.
A balance in a qualified employer retirement plan, such as a 401(k), is not included in the December 31 traditional IRA value reported on Form 8606. Separate statutory rules can apply to rollovers between IRAs and eligible employer plans, so those transactions should be analyzed separately.
An Example of the Pro Rata Calculation
Assume a taxpayer has $12,000 of traditional IRA basis available for the Form 8606 calculation. During the year, the taxpayer converts $25,000 from a traditional IRA to a Roth IRA, takes no other traditional IRA distributions, and has a total December 31 value of $75,000 in all traditional IRAs. Assume there are no outstanding rollovers or other transactions that change the Form 8606 calculation.
For this simplified example, the relevant total is $100,000: the $75,000 year end traditional IRA value plus the $25,000 converted during the year.
The $12,000 of basis represents 12 percent of that $100,000 total. Applying that percentage to the $25,000 conversion produces $3,000 of nontaxable basis recovery and $22,000 of taxable conversion income.
IRA Basis Is Especially Important With Backdoor Roth Conversions
The term backdoor Roth is commonly used to describe a strategy in which a taxpayer makes a traditional IRA contribution that is treated as nondeductible and then converts money from a traditional IRA to a Roth IRA. This strategy is often considered when the taxpayer's income prevents a direct Roth IRA contribution under the income limitations of Internal Revenue Code Section 408A(c)(3).
The conversion is not automatically tax free merely because a recent traditional IRA contribution was nondeductible. Existing pretax balances in traditional IRAs, traditional SEP IRAs, or traditional SIMPLE IRAs can cause part of the conversion to be taxable under the aggregation and pro rata rules.
If the taxpayer has no other applicable pretax traditional IRA amounts, converting an amount shortly after making a nondeductible contribution may result in little or no taxable conversion income. Earnings or other changes in value before the conversion can affect the result, and the taxpayer's December 31 traditional IRA balance is also part of the Form 8606 calculation.
The year end IRA balance is therefore an important part of Roth conversion planning. A transaction that appears simple when looking at only one IRA account can produce a different tax result once all applicable traditional IRA balances are considered.
Do Not Rely Solely on Your Financial Institution to Establish Tax Basis
Financial institution records can provide important evidence of IRA contributions, distributions, transfers, and account values. They do not necessarily establish whether a traditional IRA contribution was deducted on the taxpayer's federal income tax return or how much unrecovered basis remains.
Whether a contribution was treated as deductible or nondeductible is ultimately determined from the taxpayer's tax reporting and applicable tax rules. Form 8606, prior income tax returns, Forms 5498, and distribution records can therefore become important evidence of the taxpayer's basis history.
This becomes particularly important when an IRA is transferred between financial institutions. A transfer between IRA custodians does not by itself eliminate the taxpayer's remaining traditional IRA basis, but the new account statement may not contain the historical tax information necessary to establish that basis.
What Records Should Be Retained?
The Instructions for Form 8606 specifically direct taxpayers to retain records needed to verify the nontaxable portion of IRA distributions until all distributions are made.
The IRS identifies records that include:
- Applicable federal income tax returns for years in which nondeductible traditional IRA contributions were made
- Forms 8606 and supporting statements, attachments, and worksheets for all applicable years
- Forms 5498 or similar statements showing traditional IRA and Roth IRA contributions
- Forms 5498 or similar statements showing traditional IRA values for years in which distributions were received
- Forms 1099-R reporting IRA distributions
These documents should be treated as part of the taxpayer's long term retirement account tax records rather than merely as support for a single year's income tax return.
What Happens If an Old Form 8606 Is Missing?
A missing Form 8606 should not be ignored. The first step is to reconstruct the taxpayer's IRA history and determine whether nondeductible contributions were actually made, whether deductions were claimed for those contributions, and whether any basis was subsequently recovered through distributions or conversions.
Potential evidence can include prior income tax returns, Forms 5498, Forms 1099-R, account statements, contribution confirmations, prior Forms 8606, and records from former financial institutions.
The appropriate corrective filing depends on the taxpayer's particular facts and what was reported on the original income tax returns. The Instructions for Form 8606 contain procedures for amended reporting in certain circumstances. Internal Revenue Code Section 6693(b) also provides a $50 penalty for failure to file a required form relating to nondeductible contributions unless the failure is due to reasonable cause.
The absence of an old Form 8606 does not, by itself, establish that the taxpayer has no basis. IRS guidance states that when nondeductible contributions were not reported, traditional IRA distributions will generally be treated as taxable unless the taxpayer can establish with satisfactory evidence that nondeductible contributions were made.
A Tax Court Case Shows Why the Records Matter
The importance of preserving IRA basis records is illustrated by Shank v. Commissioner, T.C. Memo. 2018-33.
The taxpayer had received a $27,745 traditional IRA distribution but lacked complete tax and business records from the period when the IRA had originally been funded. He testified that he had been a high wage earner and had been unable to deduct his original IRA contributions. Other evidence included an account statement showing an aggregate cost of $4,760 for the original investments and Forms 5498 showing that no additional contributions had been made during later years covered by those records.
The Tax Court found the taxpayer's testimony credible and, using the available evidence and principles derived from Cohan v. Commissioner, determined that he had established $4,760 of basis. The remaining $22,985 of the distribution was taxable.
The case does not mean that missing IRA basis can always be estimated. The taxpayer still bears the burden of providing a reasonable evidentiary basis for the amount claimed. The practical lesson is that reconstructing IRA basis years later can be considerably more difficult than preserving Forms 8606 and supporting records when the contributions are made.
Common IRA Basis Mistakes
Several recurring problems can cause taxpayers to lose track of traditional IRA basis or report an incorrect taxable distribution or conversion.
- Making a nondeductible traditional IRA contribution but failing to file Form 8606
- Failing to carry remaining basis from the prior applicable Form 8606 into the current calculation
- Looking only at the IRA from which a distribution or conversion occurred
- Forgetting a traditional SEP IRA or traditional SIMPLE IRA when completing the aggregation calculation
- Combining one spouse's traditional IRA basis with the other spouse's basis
- Failing to reduce remaining basis after basis has been recovered through prior distributions or conversions
- Assuming that transferring an IRA to a new custodian eliminates the need for historical tax records
- Completing a Roth conversion without first reviewing all applicable traditional IRA balances
The Cost of Losing the Records Can Appear Years Later
Traditional IRA basis is unusual because the tax consequence of poor recordkeeping may not become apparent for many years. A nondeductible contribution made today could affect a Roth conversion years from now or a retirement distribution decades later.
Without adequate records, a taxpayer may have difficulty establishing that part of the traditional IRA represents previously taxed money. That can create a risk that more of a future distribution or conversion is reported as taxable than would have been necessary if the basis had been properly documented.
The better approach is to preserve Form 8606 and its supporting records for as long as unrecovered basis remains. When tax preparers or financial institutions change, the IRA basis history should remain with the taxpayer's permanent retirement tax records.
Before Your Next IRA Distribution or Roth Conversion
If you have made nondeductible traditional IRA contributions, review your accumulated basis before taking a significant traditional IRA distribution or completing a Roth conversion. This review can be particularly important when you have multiple traditional IRAs, an old traditional SEP IRA or traditional SIMPLE IRA, prior Roth conversions, or missing Forms 8606.
I assist taxpayers with reconstructing traditional IRA basis, reviewing prior Forms 8606, analyzing Roth conversions, and determining the taxable portion of IRA transactions. Reviewing the basis history before completing a transaction can also identify tax planning considerations that may not be apparent from the balance of a single IRA account.
Contact Steven J. Cashiola, CPATax Authority and Reporting Guidance
Internal Revenue Code Section 219, deductions for contributions to individual retirement accounts.
Internal Revenue Code Section 408(d)(1) and Section 408(d)(2), taxation and aggregation of IRA distributions.
Internal Revenue Code Section 408(d)(3)(H), special Section 72 rules for certain IRA distributions rolled into eligible employer plans.
Internal Revenue Code Section 408(o), designated nondeductible contributions and reporting requirements.
Internal Revenue Code Section 408A(c)(3), income limitations applicable to direct Roth IRA contributions.
Internal Revenue Code Section 408A(d)(3), Roth IRA conversion rules.
Internal Revenue Code Section 6693(b), penalties relating to reporting nondeductible IRA contributions.
IRS Form 8606 and Instructions for Form 8606, Nondeductible IRAs.
Shank v. Commissioner, T.C. Memo. 2018-33.
Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).
