The tax-free portion of the rollover from KPERS to the IRA annuity became basis in nondeductible traditional IRA contributions in your IRA annuities. This nontaxable amount should have been present in box 5 of the 2008 Form 1099-R that reported the distribution from KPERS. You should have included this taxable amount on line 2 of the first Form 8606 you were required to file subsequent to the distribution from KPERS. With respect to traditional IRAs, Form 8606 Part I is required to be filed whenever you make a regular nondeductible contribution to a traditional IRA, or you have basis in nondeductible traditional IRA contributions and make a distribution from your traditional IRAs (except for distributions that are qualified charitable distributions or HSA funding distributions.
Did your 2008 Form 1099-R from KPERS show the nontaxable amount in box 5?
Did you file Form 8606 when required as described above and, if so, did you include the nontaxable amount from KPERS on line 2 of the first Form 8606 you filed after the distribution from KPERS?
Did you report on your tax returns the distributions from your IRA annuity? They must be reported and the taxable amount determined on Form 8606.
It seems odd that Kansas would challenge your reporting of the nontaxable portion of an IRA distribution without the IRS first doing so. Kansas has no way to know how much of your IRA distribution is nontaxable because Kansas has no way to know how much basis you have in nondeductible traditional IRA contributions.
Also, the IRS has not provided any specific guidance on how to determine the year-end value of an annuity in payout status for the purpose of completing line 6 of Form 8606. If the annuity company provided a year-end value (reported to the IRS on Form 5498 and to you on either Form 5498 or a year-end statement), that's the value you must include on line 6. In the absence of a year-end value reported by the annuity company, individuals have taken various approaches such as the aggressive approach of treating the year-end value as $0 or a less aggressive approach such as using the current surrender value if one is provided or the current actuarial value of the annuity.
