Most advisors and clients may understand the mechanics and importance of tracking IRA basis, where failing to accurately track the basis of an IRA can result in the funds being taxed twice, which is obviously a situation that no one wants to encounter.
Inherited IRAs, however, present an entirely different set of complications—in many cases, the person who inherits the original IRA has absolutely no idea whether the original account owner’s contributions were made on a pretax or after-tax basis. Because of this potential complication, the person who inherits the IRA needs the advisor’s immediate assistance in avoiding the potential for double taxation of these funds.
Deductible vs. Nondeductible Contributions
Once a client’s income exceeds the annual inflation-adjusted thresholds, he or she is no longer entitled to take a tax deduction for an IRA contribution — in other words, the client is not able to make pretax contributions to the IRA. A client can, however, 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These nondeductible contributions form the “basis” in the client’s IRA, and are withdrawn tax-free (unlike traditional, deductible contributions, which are taxed under the general rules upon distribution).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If a client’s IRA contains basis, then a portion of each distribution will represent basis — and that amount will be withdrawn tax-free.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.