Contributed by: PhillipB, FreeTaxUSA Agent, Tax Pro
Most people contribute money to traditional IRAs to help save them money on their tax return with the IRA deduction. If the contribution is deducted from income, all the money is taxable when it is withdrawn. Deducted IRA contributions have zero basis because the contributions were already deducted, or the money in the account is treated as if it has never been taxed.
If you contribute money to a traditional IRA without claiming a deduction, or when you make contributions to Roth IRAs, the contributions are being made with money that is considered taxed since contributions are made with post-tax money or are taxed on your tax return. These IRA contributions have basis equal to the amount of the contribution.
Basically, IRA basis means that money you put in the account can be returned to you without being taxed again.
Basis in Traditional IRAs
Everyone can contribute to traditional IRAs if they have taxable earned income (income from a W-2 job or self-employment income). Not everyone can deduct their contributions. Taxpayers (and their spouses) who have retirement plans at work are subject to some income limits for the IRA deduction. If their income is over those limits, their contribution is not deductible.
Basis in traditional IRAs are returned to the taxpayer in a pro-rated manner determined by the total basis in their combined IRA (traditional IRA, SEP-IRA, and SIMPLE IRA) and the total balance in the IRA. For example, if Harold contributed to a traditional IRA for 20 years and was his only IRA account, he may have a balance of $200,000. If there was one year where his income was too high to take a deduction, he may have a basis of $6,000. When he starts taking distributions, 3% of his distributions will be tax-free because 3% of the total IRA has basis.
Taxpayers whose income is too high to make Roth IRA contributions, often make nondeductible traditional IRA contributions instead. If they don’t have a balance in traditional IRAs, they can convert their nondeductible traditional IRA to a Roth IRA tax-free (or partially tax-free). This is more commonly known as a backdoor Roth. If their traditional IRA has a balance that exceeds their basis, they can still convert the traditional IRA to a Roth in a partially tax-free conversion.
Basis in Roth IRAs
Since all contributions to Roth IRAs are not deductible, all Roth IRA contributions have basis. The biggest benefit to Roth IRAs is that distributions are nontaxable after retirement, which the IRS has determined can start at age 59 1/2. So, Roth IRA basis is not important when normal retirement distributions start being taken. However, the basis of your Roth IRA is important if you take money out of the account before you reach retirement age.
Early distributions from a Roth IRA are usually partially taxable. The portion of the withdrawal that has basis is a nontaxable return of already taxed money, but the portion of the withdrawal that is money the account earned is taxable earnings. Therefore, tracking Roth contributions is very important in making sure you don’t pay more tax than you should if you need to take money out of the Roth IRA early.
In short
IRA basis simply means money that has been put in an IRA that has already been taxed (or was never deducted from taxable income). You need to track basis because you want to make sure you can calculate the correct amount of taxable withdrawals from your IRA.