The tax rules governing individual retirement accounts can be surprisingly complicated. In many cases, it’s entirely up to the account owner to ensure compliance.

While most IRA contributions are made with pre-tax dollars and generate current tax liability when withdrawn, it’s also possible that a client’s IRA could contain nondeductible contributions — also known as the IRA “basis.” The funds that constitute the basis have already been taxed so aren’t subject to taxation a second time when withdrawn despite the generally taxable nature of a traditional IRA.

Failing to accurately track and account for IRA basis can — and often does — result in a situation where a client is taxed twice on IRA funds. While filing a missed Form 8606 can result in a small ($50 or $100) penalty, it’s also possible that the penalty can be waived for showing reasonable cause. Further, the penalty is often minimal when compared to the possibility of paying taxes twice on the same funds.

Many clients believe that their IRA custodian is responsible for tracking basis. That is incorrect — making it critical for account owners and their advisors to understand the rules and apply them correctly.

IRA Basis: the Basics

Most often, clients make pre-tax contributions to traditional IRAs and use a Roth vehicle to make after-tax contributions. However, for clients covered by an employer-sponsored retirement plan whose income exceeds the annual inflation-adjusted thresholds, the tax deduction for traditional IRA contributions is no longer available. In other words, it’s always possible that a client will not be eligible to make pre-tax contributions to an IRA but remain eligible to make nondeductible contributions.

After-tax funds rolled over from a traditional 401(k) will also be added to an account's basis.

When an account contains both deductible and nondeductible contributions, a pro rata rule applies. A proportionate percentage of each dollar withdrawn will be taxable, so pre-tax contributions are taxed and after-tax contributions are not taxed again upon withdrawal. The same pro rata rules apply when a taxpayer converts traditional IRA funds to a Roth account.

For example, assume that a taxpayer has accumulated $90,000 in pre-tax contributions to an IRA and rolled over $10,000 worth of after-tax contributions from an employer-sponsored 401(k). The account balance would be 90% taxable and 10% nontaxable — and any withdrawal would also be 90% taxable and 10% nontaxable.

Distributions are prorated across all of the client’s traditional IRAs, including SEP and SIMPLE IRAs. There is no way to simply withdraw the after-tax or pre-tax amount.

Avoiding Double Taxation

IRA custodians are not responsible for keeping track of an IRA’s basis. They do not keep any information on the breakdown of the account owner’s contributions.

Clients are responsible for tracking IRA basis on Form 8606, which must be filed with the Internal Revenue Service if they made any nondeductible contributions to an IRA for the year, or if they received a distribution from an account that had a basis greater than zero.

Further, the form is required if the client executed a Roth IRA conversion. Form 8606 must also be filed if the client receives a distribution or transfers funds from an inherited IRA that has basis.

IRA custodians report regular distributions from a traditional IRA as fully taxable because they do not know how much of any given account consists of after-tax contributions. They'll state the full amount of the distribution on Form 1099-R, Box 1: Gross Distribution and Box 2a: Taxable Amount. The custodian will also check Box 2b: Taxable Amount not Determined. Many clients don't realize that this is to give them the opportunity to calculate the taxable amount of the distribution to include on their tax return.

Although clients often fail to file Forms 8606, the mistake generally can be fixed. Account owners will have to retroactively file a Form 8606 for each year they made nondeductible contributions. If they have already taken a distribution and failed to account for the nondeductible portion, they must file a Form 8606 for the year of the distribution and report the breakdown. They’ll also have to file an amended return for the year of distribution to ensure that they aren’t paying taxes on the after-tax portion of the distribution.

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