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These nondeductible contributions form the “basis” in the client’s IRA, and are withdrawn tax-free (unlike traditional, deductible contributions, which are taxed under the general rules upon distribution).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If a client’s IRA contains basis, then a portion of each distribution will represent basis — and that amount will be withdrawn tax-free.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.
Tracking IRA Basis: The Mechanics
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 under pre-tax reform recharacterization rules). 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 — but the primary penalty for failure to properly track basis is the possibility of double taxation.
Complications With Inherited IRA Basis
The initial complication presented by inherited IRAs and basis tracking is that if the original account owner did not keep detailed records of the account basis or properly file Form 8606, the person who inherits the account may have no idea which proportion of the account came from nondeductible contributions, which are nontaxable upon withdrawal.
In many cases, this will mean that an advisor must investigate to determine whether contributions were made on a pretax or after-tax basis. This can often be accomplished by comparing the original account owner’s income tax returns to records of his or her IRA contributions. If the client discovers that the original account owner failed to report basis, he or she can file a Form 8606 independently of his or her tax return, and the IRS has indicated that it will accept these forms.
Determining whether basis exists in the account can also be accomplished by looking at the original account owner’s income levels for the years in question — in fact, a recent court case allowed the taxpayer to show basis by, among other things, establishing that his income exceeded the threshold levels for deductible contributions when the contribution was made.
For clients who inherit an IRA, the importance of initially investigating the account’s basis cannot be overstated — and this is one area where an advisor’s advice can be invaluable.
- See previous coverage of planning for inherited IRAs in Advisor’s Journal.
- For in-depth analysis of estate planning for retirement accounts, see Advisor’s Main Library.
- Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.