Advisors and clients alike may believe they have the tax rules that govern IRA and Roth IRA distributions down cold—IRA distributions are taxable and Roth IRA distributions are tax-free. Unfortunately, like so many other areas under IRS jurisdiction, these seemingly simple cardinal rules can become exponentially more complicated based on any number of factors. Rollovers, conversions, nondeductible contributions and inherited accounts can all have an impact on how distributions are taxed.

This is where the often-overlooked rules for tracking IRA basis can become critical to helping clients avoid taxes and penalties—and it is generally true that the financial advisor is the person best suited to helping the client both understand and track IRA basis.

The Importance of IRA Basis Tracking

When clients think of IRA contribution limits, they generally think of the amount that the client may contribute and deduct from income (i.e., $5,500 in 2016, with a $1,000 catch-up provision for clients age 50 and older). However, deductions are limited for clients whose income exceeds the annual inflation-adjusted thresholds (in 2016, the deduction phases out for single taxpayers when income is between $61,000 and $71,000, and for married taxpayers when income is between $98,000 and $118,000).

However, a client may make nondeductible contributions to an IRA even when his or her income is too high to qualify for a tax deduction. These nondeductible contributions form the “basis” in a client’s IRA, and are withdrawn tax-free (unlike traditional, deductible contributions, which are taxed under the general rules upon distribution). After-tax funds that are rolled over from another retirement account will also be added to the account’s basis.

If a client’s IRA contains basis, then a portion of each distribution will represent basis—and that amount will be withdrawn tax-free. If a taxpayer maintains multiple IRAs, the cumulative amount of nondeductible IRA contributions is used in determining the portion of a withdrawal from any particular account that is nontaxable.

Form 8606: Tracking Basis

Clients keep track of IRA basis on Form 8606, which must be filed with the IRS if the client made any nondeductible contributions to an IRA for the year, or if he or she received a distribution from an account that has a basis that is greater than zero.  Further, the form is required if the client made a Roth IRA conversion (unless the entire amount was later recharacterized).  Form 8606 must also be filed if the client receives a distribution or transfers funds from an inherited IRA that has basis. 

A $50 penalty applies for failure to file an annual Form 8606 when one is required, and a $100 penalty applies to clients who overstate IRA basis.

Basis and Roth IRA Distributions

Generally, all contributions and conversions to Roth IRAs are after-tax, nondeductible contributions—meaning that distributions are generally taken tax-free. However, this may not be the case for certain “premature” Roth IRA distributions.

A premature Roth IRA distribution is one that is withdrawn before the funds become “qualified” for withdrawal. Generally, Roth IRA contributions become qualified (and distributions become tax-free) once the Roth has been held for five years and the account owner is at least 59 ½. After this point, basis tracking is no longer relevant. 

However, basis tracking is important for Roth IRA holders initially because any premature distributions are withdrawn based upon ordering rules that determine which Roth funds are distributed first—Roth IRA contributions are distributed first, followed by conversions and, finally, earnings on the account value. 

If the client has executed multiple conversions, the funds that were converted the earliest are withdrawn first. Further, the portion of a conversion that is pre-tax is withdrawn before any portion of a conversion that was after-tax. If the converted funds were not kept in the Roth for at least five years, a 10 percent early distribution penalty applies if the client withdraws the funds before he or she reaches age 59 ½.

Conclusion

IRA basis tracking is a task that is often overlooked—but understanding the rules can help your clients avoid unnecessary taxes and reporting penalties.

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