All those tax-related forms which come with having an IRA, what they mean, and what to do with them.

IRA stands for Individual Retirement Account (or, possibly, the collection of all such accounts), and each IRA account you have generates a small torrent of paperwork, both throughout the year and after the end of the year. We’re going to try to make some sense of all that, but first we need to review a few basics about how IRAs work.

An IRA is not a specific investment (such as a kind of stock, or bond, or certificate of deposit, or insurance product such as an annuity). Rather, it’s a kind of account which may be thought of as a container which may hold any of those various investment products. The distinguishing feature regarding the IRA is that the potentially taxable events are not what takes place inside the container, but rather, when money crosses into or out of the container itself.

What goes in, what goes out, and what’s taxed

Suppose the IRA in question is a brokerage account. If you open the account by depositing $5000, and then within the account, you invest that money in a variety of stocks, the tax-specific event was the deposit of that $5000. Whether the stocks go up or down, or throw off dividends, or even if you sell the stocks later on, there is no tax impact – unless and until you withdraw money from the account.

When you actually withdraw some of the money – money crosses the “barrier” between “in the IRA” and “out of the IRA” – only then will the tax consequences come due.

Now, the initial deposit may have tax consequences. You may or may not be permitted to deduct that contribution from your income when computing your income taxes (making it a “deductible” contribution and thereby lowering your income taxes).

And when you take the money back out, you may owe income taxes on all or some of the withdrawal. Whether you owe taxes on the withdrawal – and how much – may depend on whether or not you deducted the contributions in the first place.

In the simple, traditional situation, the deposit was fully deductible. That means that the entire contribution was, effectively, “pre-tax” dollars. If your IRA was funded entirely with only pre-tax money like that, then when you take a distribution, the entirety of that distribution is also usually going to be taxable – regardless of how much of the distribution represents the original contributions and how much represents the growth or return on that investment. Since the original contributions were never previously taxed, they get taxed when they come back out.

In some cases, however, when a deposit is made to the IRA, the tax deduction may not be allowed. When that happens, the deposit is non-deductible and may be thought of as “after-tax” money. This means that effectively the balance in your IRA includes a mix of money which has already been taxed, as well as money which hasn’t yet been taxed. When you take money back out of such a mixed IRA, it’s important to know what the proportion of “after-tax” money is in order to ensure that it’s not taxed a second time.

The term for the amount of after-tax money in an IRA is basis. And when your IRA has a non-zero basisyou generally only pay taxes on the portion of the withdrawal which represents how much it went up in value above the basis.

Returning to our $5000 example. Suppose you put in $5000 and were not allowed the tax deduction. And over time, the investment in the account went up by $2000. And, finally, you withdrew the full $7,000. Since the account had $5000 basis, you’ll owe income taxes on only the $2000 of growth.

One very important – and not obvious – thing to remember about basis and the taxability of IRA withdrawals is that in the context of basis you have one IRA which may be composed of many IRA accounts. The basis is not attached to any particular IRA account. If you take a withdrawal from any IRA account, the basis attributable to all of your IRA accounts combined must be factored in. 

RMDs

One more general issue. Once you’re over 70–1/2, you have to take annual distributions (which are likely to be taxable) – whether you need the cash or not. These are called “Required Minimum Distributions” (or sometimes “Minimum Required Distributions”). You can take out more but if you take out less than the RMD, you may be subject not only to taxes, but also potentially huge penalties, too. So don’t miss your RMDs.

And the collection of tax forms

With all that in mind, let’s see a few of the forms you’ll be encountering.

• 5498

  Your IRA custodian will send you, every year, sometime after the new year, a form 5498. This form simply records what the IRA’s year-end balance was, how much you added during the year, whether you’re going to be subject to RMDs (and that year-end balance will be used to help you compute those RMDs).

  The 5498 may have a lot of other information, but the main things to look for are (a) the sum of any contributions you made to that IRA account during the year; (b) the year-end fair market value of the account; (c) any contributions to the account which were rollovers from other IRAs or retirement plans; (d) whether you need to take RMDs (and possibly how much);

  There may be a variety of other things which get reported on a 5498 such as any Roth IRA contributions, the account type (SEP, SIMPLE, Roth, etc).

  And since you are allowed to make contributions to an IRA for a given year all the way up until tax filing – which is several months after year-end – you may get a 5498 early in the year and an updated one several months later.

  Each individual IRA account will have its own 5498 each year.

• 8606

  This one is your responsibility to prepare. Your custodian (i.e., the brokerage) won’t send it to you, but, rather, you or your accountant will prepare it when doing your taxes – if you need it.

  The 8606 is where you track and report any basis in your IRA. And as noted above, basis applies to the aggregate of all your IRA accounts, not to an individual account). No matter how many IRA accounts you have, if you have an 8606 at all, you’ll only have the one.

  The custodian cannot generate your 8606 because the custodian has no way of knowing whether or not you deducted your IRA contributions from your income when you filed your taxes. The 8606 is where you track the sum of any non-deductible (“after-tax”) contributions you may have made to an IRA. Any time you make a non-deductible contribution to your IRA, you add basis. And any time you take a distribution or withdrawal from your IRA, you may be removing basis. Since the taxes you may owe when you take distributions depends on the basis (and the ratio between the basis and the account value), it’s absolutely essential that you track the basis correctly in order not to pay double taxes.

  You may not have to file an 8606. If you always deduct your IRA contributions, you have no basis and therefore, no 8606 to track that basis.

  Moreover, even if you have basis from having made non-deductible contributions in the past, if you’ve made no such non-deductible contributions this year you won’t have to file an 8606 this year. But make absolutely sure you keep handy a copy of the last one you filed – because you’re going to have to refer to the last previous 8606 you filed when you file another new one. The 8606 tracks changes to basis – so it’ll need to be filed in any year in which there were non-deductible contributions or any year in which there were distributions, too. So while there may be years where you skip filing the 8606, make sure you always have a copy of the last one you filed. 

  Since this one is your responsibility, we encourage you to ensure that if you were supposed to have an 8606, you have it, and know where it is. If you’re not sure – check with your accountant or consult your taxes every year going back as long as you may have made IRA contributions. People lose track of this very easily, and even accountants sometimes miss this. Incorrect or missing 8606 forms are one of the most common errors in IRAs and taxes we encounter.

• 1099-R

  There is actually an entire alphabet soup of different types of 1099 forms (1099-INT, 1099-B, 1099-DIV, 1099-MISC, and 1099-R are perhaps the most common ones). What they all have in common is that they are how someone else reports to the IRS that you were given money one way or another (such as interest, dividends, proceeds from the sale of securities, miscellaneous income, or distributions from retirement accounts – respectively). Whoever paid you is responsible for filing the 1099 (and providing you with a copy of it).

  If you took a distribution from an IRA account, the custodian will issue you a 1099-R. You may even get a 1099-R in cases of distributions which aren’t taxable (such as a rollover from an employer’s retirement plan which you rolled directly into an IRA).

  You’ll get one 1099-R per IRA account – if there were any distributions from that account that year. If you’re not taking any distributions, you may not get any 1099-Rs. But you may have as many 1099-Rs as you have accounts. Make sure you have this on hand when you’re working on your annual income taxes.

And the last word

Don’t forget – if you’re subject to RMDs, the IRS will know and figure it out. And they can look for the 1099s and 5498s to figure out if you actually took those distributions. So every year, look for those forms, check the numbers, and make sure you take any distributions you’re required to take. The penalties for missing RMDs can be awful. 

And remember to track your basis on your 8606.

And, of course, if you do owe taxes, pay them!

Finally, if you have any questions, please make sure to consult with a trusted professional.