Basis in Your Traditional IRA
While most distributions from a traditional IRA are taxable, sometimes distributions can include after-tax dollars. These after-tax dollars are known as “basis.” Handling and tracking basis in your traditional IRAs can be challenging, but it is important to get it right. If mistakes are made, double taxation can occur. That is a result no IRA owner wants.
What Is Basis in a Traditional IRA?
Basis in a traditional IRA consists of after-tax dollar contributions. Basis in your IRA can come from two sources:
- Nondeductible tax-year IRA contributions (including those that are done as part of the backdoor Roth IRA conversion strategy).
- After-tax funds that are rolled over from a plan like a 401(k). (This does not include funds from a Roth plan account, which cannot be rolled over to a traditional IRA.)
Earnings on basis amounts are tax deferred, not tax free. When earnings are distributed, they are taxable as ordinary income. While basis avoids the 10% early distribution penalty, earnings on these after-tax dollars can be subject to the 10% early distribution penalty, if applicable.
Basis carries over to inherited IRAs. Most beneficiaries, and even their tax preparers, aren’t aware of this issue. If you inherit an IRA, you need to determine whether basis exists. Failure to adequately investigate will cause you to overpay taxes on distributions from the inherited IRA.
IRAs Are Different When It Comes to Basis
Basis in your IRA is different from basis in your investment account. In an investment account, basis is the amount paid for the asset. Growth on that investment is taxed as long-term or short-term capital gain. At the death of the owner, a beneficiary gets a step-up in basis to the current market value. There is never a step-up in basis in any retirement account.
Form 8606
Someone, somewhere, has to be tracking the basis in IRA accounts. Did you think it was the IRA or custodian? You would be wrong. The “I” in IRA stands for “individual.” The individual is responsible for tracking their own basis.
You can track your basis using Form 8606. This form is filed with your tax return each year that you make an after-tax contribution to your traditional IRA, and each year that you take a distribution from your IRA (if the IRA contains basis).
Filing Form 8606 to track your basis is important. No one wants to pay taxes on funds that have already been taxed!
By Sarah Brenner, JD
Director of Retirement Education
Ed Slott and Company, LLC
Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.