Saving is a good thing- sadly, as Americans we don’t do enough of it. The law provides for many options when it comes to tax-favored accounts…whose contributions are tax-free. The more you put into a tax-favored account, the less federal income tax you will pay.
One popular example of a tax-favored account is the Individual Retirement Account (IRA). Contribute a few thousand each year and by the time you retire you should have a nice amount for your golden years. For the super-savers among us, there is temptation to stock away as much as humanly possible into these types of accounts. Too bad there are contribution limits.
Limits on IRA Contributions
For both major types of IRAs, the contribution limit for 2013 was $5,500. It goes up a bit each year, around $500 or so, although not every year. If you are over age 50, you can contribute an extra $1000 to your IRA. If you go over the limit, you must file IRS Form 8606 and pay a fine. The excess contribution fine is 6%.
You would think that staying under the IRA contribution limit would be easy- but there are circumstances when you need to change what you’ve already put into your account. For example, if you contribute the maximum amount to your traditional IRA during the year then find out at the end of the year when doing taxes that your Modified Adjusted Gross Income puts you over the limit for contributing the maximum amount to your Traditional IRA, you have contributed excess amounts without meaning to.
Form 8606 is for Recharacterizations and Excess Contributions
What would you do in this situation? Use IRS Form 8606 to recharacterize that IRA contribution into a Roth IRA contribution, which has a higher limit for higher MAGIs. The other option is to just leave it there and pay the 6% fine. Then it would be said you make a nondeductible contribution to your IRA (the title of Form 8606). In either case, you must fill out and submit IRS Form 8606.
Once you’ve made a nondeductible contribution to your IRA, any distribution you take from here on out will mean you have to fill out Form 8606 that year. For this reason alone it’s good not to make any nondeductible contributions!