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Personal Finance

Tax Reporting for Your IRA

Some forms you must file, but others you should file even if not required.

If you own an IRA or Roth IRA, here are some tips regarding tax forms you must file--or should file even if not required. It's not always self-evident how the recipient is supposed to report IRA distributions!

If You Received Form 1099-R
1099-R is the form the IRA provider uses to tell the IRS that it has made a distribution to you from the IRA. Generally IRA distributions are taxable (includible in gross income), so normally you are going to have to report the amount of the distribution on your income tax return, Form 1040.

Your first step should be to make sure the Form 1099-R is correct. Aside from errors in the amount, here are some other common reporting mistakes: A direct IRA-to-IRA transfer is not reportable as a distribution at all--but some IRA providers may mistakenly report such a transfer anyway.

The letter and number codes on the Form 1099-R all mean something; check the list of codes in the IRS instructions to Form 1099-R to make sure your IRA provider has used correct codes. For example, if you are over age 59 1/2, the 1099-R should not show Codes 1 or 2, which are only for "early distributions" (under age 59 1/2).

If you discover an error, try to get the IRA provider to issue a corrected 1099-R, because an error may lead to an unnecessary IRS audit. If you don't succeed in getting a corrected 1099-R, attach a statement to your return explaining why your reporting of the distribution does not match the 1099-R.

The next reporting dilemma concerns how much of the distribution is taxable. For example, a distribution may be nontaxable because it is a qualified distribution from a Roth IRA (Code Q). That one is easy for the individual taxpayer--on line 15a of Form 1040, you put the gross distribution (as indicated on Form 1099-R) and on 15b you enter the "taxable amount," which is zero.

Things get tricky if you have aftertax money in your IRAs. The usual way an individual winds up with aftertax money in an IRA is by making nondeductible contributions to an IRA over the years. See IRS Publication 590-A regarding which IRA contributions are deductible. Less commonly, already-taxed money can wind up inside an IRA due to a rollover of nontaxable distributions from a qualified plan or due to an "excess IRA contribution" that was not timely withdrawn.

If you have aftertax money in an IRA, then almost any distribution you take from any one of your IRAs will "carry out" some of the aftertax money along with pretax (taxable) money. As a reminder, all of your IRAs are considered to be one single account (i.e., they are aggregated) for purposes of determining what proportion of a distribution from any one of them is aftertax money. But the IRA provider will not calculate that for you--Form 1099-R will not indicate what portion of your distribution is a distribution of tax-free aftertax money. Even if the IRA provider is aware that it received nondeductible contributions to the account from you, the IRA provider has no way to know what other IRAs you may own, so it can't apply the aggregation formula. Instead, the IRA provider will put an "X" in Box 2, "taxable portion not determined." You will need to calculate the taxable portion yourself using Form 8606 (see below).

Here's a final zinger from Form 1099-R: If the distribution was a "qualified charitable distribution" (QCD), the IRA provider makes no special annotation at all! It will be simply reported as a distribution with no indication that it might be nontaxable. It will be up to you to remember that the distribution was nontaxable because it met the various requirements of the QCD. Then you, the IRA owner, must use lines 15a and 15b to separate the gross distribution from the taxable portion.

Form 8606 to Keep Track of 'Basis'
Form 8606 tracks the IRA owner's aftertax contributions to the IRA--what comes in, what goes out, and how much aftertax money is left in the account at the end of the year. The aftertax money you have in your IRAs is your "basis" (strictly speaking your "investment in the contract"), and it is very valuable to keep track of that basis because that money will eventually come out to you tax-free.

You are not required to file Form 8606 for any year when there are no contributions to or distributions from the IRA and no conversions to or distributions from any Roth IRA. However I recommend filing it every year if your IRA has aftertax money in it, even if you didn't take any distribution (or make a contribution to) the IRA for the particular year. Although the existence of aftertax money inside an IRA can be established even if the Forms 8606 were not filed or cannot be located, the easiest way to establish your "investment in the contract" is to have a history of consistent Forms 8606 filed each year documenting the increases, decreases, and remaining year-end balance.

Form 990 for 'Unrelated Business Income'
IRAs are generally tax-exempt entities, so the IRA itself does not have to file a tax return, but there is one exception: Like charities, IRAs are taxable on "unrelated business taxable income" (UBTI). If your IRA is invested in stocks, bonds, or cash, you don't have to worry about this, but if your IRA is invested in a partnership or other pass-through business entity (even one that is publicly traded), your IRA may have taxable income. In that case the IRA provider is supposed to file Form 990 to report this income--and pay the tax on it out of your IRA.

Form 5329 to Get Limitations Protection
The final form is not required but is highly recommended. It is Form 5329, the form used to report IRA "penalty" taxes (such as the 50% excise tax for failure to take an RMD and the 6% annual levy on excess IRA contributions). Every IRA owner and beneficiary should strongly consider filing Form 5329 every year with the tax return, even when (as will normally be the case) there appears to be no such tax owed. There is no statute of limitations protection against IRS assertion of these penalties if no return was filed, and Form 5329 is the applicable return.

Natalie Choate will be speaking at a location near you if you live in Orlando (Jan. 14-15) or Palm Beach Gardens (Feb. 4), Fla.; Chicago (May 3); Indianapolis (June 3); Austin (Jan. 25) or Plano (May 11), Texas; Waltham, Mass. (June 1); Manhattan Beach, Calif. (April 29); Overland Park, Kan. (May 6); Toledo, Ohio (May 19); Madison, Wis. (Oct. 17); or Scottsdale, Ariz. (Nov. 11). See all of Natalie’s upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.