It’s Later Than You Think: Do You Know Your IRA Basis?

With the rising popularity of Individual Retirement Accounts (IRAs), many people may have been making yearly contributions without giving much thought to what will happen from a tax standpoint when they start taking money out of their traditional IRAs. This oversight is understandable, since many IRA contributors may be years away from retirement, and contributions, not withdrawals, are usually the primary focus.

However, when you begin taking distributions from a traditional IRA, a variety of tax issues could arise. In general, your distributions are included in your gross income. Withdrawals made before the age of 59½ are subject to a 10% penalty, in addition to ordinary income tax. This process is relatively straightforward for those who have made only deductible contributions to their IRAs, but taxation is more complicated for nondeductible contributions.

IRA Tax Basis

If all of your contributions to a traditional IRA were deductible, then you have no basis in your IRA, and your distributions are fully taxable. Basis represents the after-tax balance in your account. If you made nondeductible contributions to your IRA, the amount of your contributions equals your basis, and this money is not subject to tax upon distribution.

Deductible Contribution Limits

Prior to 1987, all wage earners could make a deductible contribution of up to $2,000 annually. But, the Tax Reform Act of 1986 limits deductible contributions for employees who are active participants in qualified employer-sponsored retirement plans with adjusted gross income (AGI), subject to certain modifications, exceeding specified amounts based on filing status. ($61,000–$71,000 for single filers; and $98,000–$118,000 for married joint filers in 2015).

Nondeductible Contributions

While some people were aware that a nondeductible contribution was permitted without regard to active participation in an employer-sponsored plan, many who made such nondeductible contributions failed to account for them by filing Form 8606 with their annual tax returns. Form 8606 properly tracks nondeductible IRA contributions in both current and prior tax years, and is the only official record of after-tax contributions (i.e., IRA basis).

Without having filed Form 8606 for years in which nondeductible contributions were made, a taxpayer will be exposed to double taxation of contributions when withdrawals are made. According to the IRS, without the proper historical record, no distinction is made between contributions made with before- and after-tax dollars, and all withdrawals are subject to taxation. In addition, there is a $50 penalty for failing to file Form 8606 for any year in which nondeductible contributions were made.

Also, consider state taxation of IRA withdrawals. Many states do not permit deductions for IRA contributions and, consequently, provide for a tax-free “return of basis.” This means that contributions are not taxed when withdrawn, but that part of the IRA account, consisting of accrued interest and dividends, is then taxed as received. However, this “return of basis” works only if the individual has kept accurate records and knows what his or her IRA basis is.

Recordkeeping

One way to determine your total deductible and nondeductible contributions is to examine your tax returns over the entire period of IRA funding. If your recordkeeping has been less than ideal, account trustees (insurance companies, banks, mutual fund companies, brokerage firms) may be able to help you reconstruct your total contributions over the years. However, be advised that such trustees usually have no record of whether your contributions were deductible or nondeductible.

If you find yourself in “IRA limbo” with respect to your IRA basis, you may want to enlist the help of a qualified professional. Remember, it is important to keep organized records of your contributions and to file the appropriate forms. However, to help avoid a tax mishap at the time of withdrawal that could undo some of the annual benefits you have enjoyed from tax-deferred savings, be sure to consult your tax professional about your unique circumstances.