Not Tracking IRA Basis? You Could End Up Paying Taxes Twice
The tax rules governing IRAs can be surprisingly complicated and, 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 While most IRA contributions are made with pre-tax dollars and generate current tax liability when withdrawn, it’s also possible that the client’s IRA could contain nondeductible contributions—also known as the IRA “basis”. The funds that constitute the IRA’s basis have already been taxed so, of course, aren’t subject to taxation a second time when withdrawn despite the generally taxable nature of a traditional IRA.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. Many clients believe that their IRA custodian is responsible for tracking basis. That belief is incorrect—meaning that it’s critical for the account owner 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, if a client is covered by an employer-sponsored retirement plan and their 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. They remain eligible to make nondeductible contributions to an IRA even when their income is too high to qualify for a tax deduction.
After-tax funds that are rolled over from a traditional 401(k) will also be added to the 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 A proportionate percentage of each dollar withdrawn will be taxable (so pre-tax contributions are taxed, and after-tax contributions are not taxed again upon withdrawal).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 a taxpayer has accumulated $90,000 in pre-tax contributions to their 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% non-taxable—so that any withdrawal would also be 90% taxable and 10% non-taxable.
Distributions are pro-rated 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 nature of the account owner’s contributions.
Clients are responsible for tracking 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 they received a distribution from an account that had a basis that is 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 conduct their own calculation and calculate the taxable amount of the distribution (and the non-taxable amount of the distribution) to include on their tax return.
Unfortunately, clients often fail to file Forms 8606. The mistake generally can be fixed. The account owner will have to retroactively file a Form 8606 for each year they made nondeductible contributions. If the client has 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 they aren’t paying taxes on the after-tax portion of the distribution.
Conclusion
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.
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