As with most investments or assets, "basis" is defined by the cost of acquiring the asset, and is used primarily in calculating the profit when selling that asset. In the case of individual retirement arrangements, basis takes on an additional importance because of the tax-deferred nature of traditional IRA accounts. You'll need to keep track of this basis so that when you take the distribution, you pay tax on the correct amounts.
Only contributions to traditional IRAs are tax-deductible. For taxpayers who are covered by employer retirement plans and those with high adjusted gross incomes, the full amount of annual IRA contributions are not tax-free. The Internal Revenue Service defines IRA basis as the amount of your nondeductible IRA contributions. Basis of inherited IRAs are calculated separately.
Taxation of Distributions
Those tax deductible contributions you made and the investment growth on them are taxable when you withdraw the money for your IRA. However, any nondeductible contributions are not taxable; you already paid tax on that income in the year you made the contribution. This is where the IRA basis comes in. You'll calculate the taxable distribution by subtracting out the IRA basis, which lowers how much tax you'll owe. The IRS supplies worksheets to calculate the taxable percentage of your distribution based on the proportion of deductible to nondeductible IRA contributions. Example: If 20 percent of your contributions were nondeductible, then 20 percent of distributions in any particular year are not taxable.
If you made any nondeductible contributions, you'll need to file Form 8606, Nondeductible IRAs, both when you contribute and when you take a distribution. Since many years may elapse between contributions and distribution, it's important to keep careful records of how much you contributed each year and separate totals for deductible and nondeductible contributions. Some IRA custodians will keep this information for you and provide it when you make a distribution.
Roth IRA contributions are not deductible so the distributions are tax free. You've paid tax on the income before contributing. While you still need to file Form 8606, your Roth contributions and distributions do not affect your traditional IRA basis.
Basis and Roth Conversions
If you convert a traditional IRA to a Roth, you'll have to pay tax on the full amount converted, unless you have basis from nondeductible contributions to the original traditional IRA. Just like a distribution, you're only taxed on the proportion of the conversion that was tax-deductible, not the full amount. If you convert an account worth $50,000 with basis of $10,000, the taxable conversion amount is only $40,000.
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