The IRS giveth, the IRS taketh away. You’ve heard of tax-favored accounts, right? The IRS practices a little bit of social engineering and tries to encourage good behavior by giving tax breaks for things we taxpayers may do in life. Contributing to tax-favored accounts usually comes with a perk that benefits you by lowering your tax liability. For example, if you contribute to a Traditional IRA, the money you put in is not counted toward your taxable income. The IRS is giving you a nice gift of lowering your taxes, while at the same time encouraging you to invest in your own future retirement years.
The IRS doesn’t just give things away, however. There are strings attached…rules and limits to the how much money you can actually shelter from taxes this way. For example let’s take the Traditional IRA again. There is a 2013 contribution limit of $5500 per year for traditional IRAs. The amount goes up a bit each year to keep up with inflation but you get the idea. If you just can’t help yourself and you contribute more than the limit, the IRS will “taketh away”…you will have to pay taxes on that amount. To report an over-the-limit contribution to your Traditional IRA and other rule-breaking actions like this, you would use IRS Form 8606. If you don’t file this form, which is called Nondeductible IRAs, there is a penalty of $50. Yes, the IRS taketh away.
What Else Is Covered on IRS Form 8606?
Let’s make sure we remember the two main types of Individual Retirement Accounts:
- Traditional IRAs. Any money (up to the IRA contribution limit) that goes into this type of account is tax-free at the time of contribution. Then, later on when you are retired and you start taking distributions from the account, you will pay taxes on those distributions.
- Roth IRAs. Any money (up to the contribution limit) that goes into this type of account is NOT tax-free at the time of contribution. However, later on in retirement when you start taking distributions, you will not have to pay income taxes on those distributions.
Sometimes we set up one type of IRA and later on change our minds and wish we’d gone with the other type. That’s OK! The IRS lets you switch and pay taxes accordingly. Switching from a traditional IRA to a Roth, you end up with what’s called a Roth Conversion IRA. In this case, you are taking an account whose contributions were tax-free when you made them, and turning it into an account where the distributions are tax free. You get away without paying taxes at either end, right?
Nope. When you convert to a Roth IRA, use IRS Form 8606 to report this and pay taxes on your contributions so far. You simply attach the form to your 1040 when you file your annual income tax return. For a peek at the form, visit the IRS website here and go here for the instructions.