Explain the Tax Basis of an IRA
IRAs are individual retirement accounts, used to build your nest egg for when you leave the workforce. Traditional IRAs offer deductible contributions but taxable withdrawals, while Roth IRAs don't allow contributions to be deducted but withdrawals aren't taxed.
The tax basis of your IRAs depends on the type of contribution that is made. This comes into play when certain withdrawals are taken or certain tax deductions are claimed.
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Function
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The tax basis in an IRA is determined by the amount of non-deductible contributions you have made. Roth IRAs do not allow you to claim a tax deduction for contributions, so all of your contributions count toward establishing your tax basis in a Roth IRA.
For traditional IRAs, most people are able to deduct their contributions, so they rarely have any tax basis for the account.
Non-Deductible Traditional IRA Contributions
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If you or your spouse can participate in a work-sponsored retirement plan, such as a a 401k plan, and your income exceeds the annual limit, you might not be allowed to deduct your contributions to your traditional IRA. Such non-deductible contributions add to the tax basis of your traditional IRA. The limits for making deductible contributions to your traditional IRA are adjusted each year for inflation.
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Taxes on Withdrawals
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Your tax basis comes into play when you must determine the taxes owed if you take an early withdrawal from your Roth IRA, or any withdrawal from a traditional IRA. The IRS allows you to take Roth distributions from your contributions before you dip into earnings. Because these contributions were made with after-tax dollars, you do not have to pay taxes on them.
When you take money out of your traditional IRA, you must split the distributions proportionally between your taxable contributions and the rest of the money. For example, if your traditional IRA account had $10,000 in non-deductible contributions, $60,000 in deductible contributions, and $30,000 in earnings, and if you took out $10,000, only $1,000 would be from your non-deductible contributions (and therefore tax-free), because only 10 percent of your total is from non-deductible contributions.
IRA Losses Deduction
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In very rare cases, you might be able to claim a loss on your IRA as a tax deduction. To do so you must close all of the IRAs of a single type, such as all Roth IRAs, and the total amount distributed from the account over the accounts' life span must be less than the tax basis of the account.
For example, if you had a Roth IRA to which you had made $50,000 worth of contributions, but when you closed it you had received only $40,000 in distributions because of investment losses, you would be able to claim a $10,000 deduction if you itemized your taxes.
Tax Filing
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When you have non-deductible contributions, you must use Form 8606 to document your contributions and withdrawals for tax purposes. When make a non-deductible contribution to a traditional IRA, the IRS needs to record it so you are not taxed on that money when it is withdrawn. When you take distributions, you use Form 8606 to determine how much of your withdrawal is tax-free.
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