Form 8606

The core problem Form 8606 solves is the prevention of double taxation. When a taxpayer makes a nondeductible contribution to a traditional IRA — typically because they or their spouse participates in a workplace retirement plan and their income exceeds the deductibility phase-out range — those after-tax dollars go into an account that will eventually generate taxable distributions. Without tracking which portion of the account represents after-tax basis, every distribution would be taxed in full, effectively taxing the same dollars twice.

Part I of Form 8606 is filed in each year a nondeductible traditional IRA contribution is made. The running total of nondeductible contributions — called the IRA basis — is carried forward from one year's 8606 to the next on Line 14. When a distribution is later taken from any traditional, SEP, or SIMPLE IRA, the taxable portion is determined by the pro-rata rule: the ratio of total basis across all such IRAs to the combined year-end value, applied to the gross distribution. This calculation ensures each dollar withdrawn is taxed proportionally regardless of which account it came from.

Part II of Form 8606 covers Roth IRA conversions. When a traditional IRA is converted to a Roth, the converted amount is generally taxable as ordinary income in the year of conversion. The after-tax basis from Part I reduces the taxable conversion amount, preventing the nondeductible contributions from being taxed again. High-income taxpayers who cannot make direct Roth contributions due to the income phase-out limits often execute a Backdoor Roth IRA strategy: making a nondeductible traditional IRA contribution and then converting it, with Form 8606 documenting the basis that makes the conversion mostly or entirely nontaxable — provided other pre-tax IRA balances do not trigger the pro-rata rule.

Part III applies to distributions from Roth IRAs. Roth accounts hold both contributions (which can always be withdrawn tax- and penalty-free) and earnings (which are tax-free if the distribution is qualified — meaning the account is at least five years old and the owner is age 59½ or older, disabled, or deceased). Part III calculates the portion of a Roth distribution attributable to basis versus earnings when the distribution is not yet qualified.

Filing history matters enormously for Form 8606 purposes. If a taxpayer failed to file 8606 in a year when a nondeductible contribution was made, the IRS provides a procedure to reconstruct basis using prior tax returns, bank records, and custodial statements. A $50 penalty applies for failure to file Form 8606 when required, but the penalty does not eliminate the taxpayer's right to claim the basis.