What is IRA basis?
When making decisions about your retirement funds, it helps to know your IRA basis. Find out what is IRA basis and how it is calculated.
When using an IRA to save for retirement, you may be allowed to make deductible and nondeductible contributions. Deductible contributions are the pre-tax contributions made to a traditional IRA while non-deductible contributions are the contributions made to a Roth IRA or other designated Roth account.
An IRA basis represents the funds that have already been taxed in your IRA. Typically, the contributions made to a Roth IRA are considered its IRA basis, since these funds can be withdrawn and invested tax-free. If you have a traditional IRA, and you made nondeductible contributions to the account, these funds will be your basis, and they will not be subject to income taxes upon distribution. However, if all your IRA contributions are deductible, there are will be no basis in your IRA.
What is a traditional IRA basis?
An IRA basis represents the IRA funds that have already been taxed, either because they were non-deductible contributions or after-tax contributions. If all your IRA contributions are deductible, there is no basis in the account, and the IRA distributions will be subject to income taxes.
Sometimes, however, IRA owners can make after-tax contributions to a traditional IRA that is designated to hold pre-tax funds. Since after-tax contributions have already been taxed, taxing them again could result in double taxation.
Usually, after-tax contributions in a traditional IRA may occur when the IRA owner has an earned income and is eligible to contribute to the account, but cannot claim a full deduction because their income exceeds the IRS income limits. This means that the IRA owner’s ability to deduct traditional IRA contributions is phased out or eliminated, but they can still contribute as long as they have an earned income.
What is a Roth IRA Basis?
A Roth IRA basis refers to the total Roth IRA contributions made to the account since you made the first contribution. Roth IRA contributions are known as “basis” since the contributions are non-deductible, and you won’t pay taxes when you make a withdrawal. Roth conversions are also considered an IRA basis since these funds are taxed when they are converted.
You must track your IRA basis to know how much money you have contributed to the account, and how much earnings the contributions brought in. By tracking your Roth IRA contributions, you can know the amount you can withdraw penalty-free before 59 ½. Generally, you can withdraw your basis at any time without owing taxes or penalties.
How to calculate your IRA basis
Here are steps to calculate your IRA basis depending on the type of IRA you have:
A traditional IRA can have a "basis" if you made nondeductible contributions to the account. To calculate the IRA basis, you must subtract all nondeductible contributions withdrawn from the total nondeductible contributions.
For example, if you made non-deductible contributions worth $10,000 to a traditional IRA, and you have withdrawn $3,000 in non-deductible contributions, the remaining $7,000 balance is the IRA basis.
If you have a Roth IRA, the contributions you make to the account are nondeductible contributions. Therefore, your Roth IRA contributions are considered your IRA basis, since the contributions are not taxed when withdrawn.
You can calculate your Roth IRA basis by adding up all contributions made to the account since the first contribution, minus any contributions withdrawn from the account. If you don't have a record of your contributions over the years, you can obtain this information from Form 5498 which is sent each year by the IRA provider.
For example, assume that you have had your Roth IRA for 12 years, and you have contributed $3,000 to the account each year. Also, you have withdrawn a total of $5,000 from your Roth IRA. In this case, the IRA basis can be calculated by taking the total contributions i.e. $36,000 minus $5,000 to get $31,000. Therefore, the IRA basis is $31,000.
Tracking your IRA Basis
If you have nondeductible contributions in your IRA, you must track the IRA basis to determine how IRA withdrawals will be taxed. Usually, if you don’t track your IRA basis, you could pay income taxes on funds that have already been taxed, resulting in double taxation.
IRA basis must be tracked using IRS Form 8606, also known as nondeductible IRAs. This form is filed alongside the annual tax return, and it keeps a record of nondeductible IRA contributions in the current and prior tax years. Without this form, there will be no distinction between the before and after-tax contributions, and any withdrawals from the IRA will be subject to income taxes. You will pay a $50 penalty if you fail to file Form 8606, and a $100 penalty if you overstate the Roth IRA basis.
If you inherited the IRA, you should check if the original IRA owner ever made non-deductible IRA contributions. Start by checking Form 8606 which is attached to the deceased's IRA owner's tax return. If there is a basis in the inherited IRA, any withdrawals of the basis will be tax-free.
Why IRA basis is important
Here are some reasons why you should track your IRA basis:
Track penalty-free withdrawals
When you know your IRA basis, you can determine how much withdrawals you can make tax and penalty-free. Any withdrawals of the tax basis will be tax-free, but you could owe income taxes and a potential penalty if the withdrawal exceeds the basis. For example, if you withdraw $10,000, and only $8,000 is your basis, you will owe income taxes and a penalty if the withdrawal is not qualified.
When you make non-deductible contributions to your IRA, you must file Form 8606 each year when filing the annual tax return. This form can help you track your IRA basis and verify the non-taxable portions of your IRA withdrawals. Failure to file Form 8606 or reporting incorrect entries can result in penalties from the IRS.