09 July 2018
The word basis can have many different meanings in tax and finance. When it comes to your IRA it refers to the portion of your IRA on which you will NOT have to pay tax. That makes it a really good thing to know (unless you enjoy paying taxes!). Unfortunately, IRA basis is one of the rare areas of the tax code where nobody else is keeping track of it for you. The IRS doesn’t. Your bank or brokerage can’t. You have to do it for yourself - and if you aren’t then you could end out paying more taxes than you need to.
The Basics on IRA Basis
There are two types of IRAs. There’s the Traditional IRA, and there’s the Roth IRA. The primary difference between the two is the timing of when the money gets taxed. The concept of the Traditional IRA is that you don’t pay taxes on the money you contribute to the account, but you pay regular tax rates on the money when it comes out. The concept of the Roth IRA is that you pay tax on the money when it is contributed to the account, but then you don’t pay any taxes on the money coming out.
If those concepts were the only rules, then I wouldn’t be writing this article. If those were the only rules, the tax basis of a traditional IRA would be 0% of the account (none of it would be excluded from taxes) and the tax basis of the Roth IRA would be 100% of the account (all of it would be excluded from taxes). But, alas, nothing can ever be that simple in tax law. There are exceptions, and it’s those exceptions this article addresses.
Basis in Your Roth IRA
The IRS uses the term qualified when referencing IRA distributions (a.k.a. withdrawals). Qualified means the distribution/withdrawal meets all the rules to keep the tax benefits of the IRA. One of the things that makes a Roth IRA distribution qualified is the age of the account holder. If you are more than 59 ½ years old when you withdraw from the Roth IRA, then the distribution is deemed qualified (tax free).
Life happens to us all, though. For a variety of reasons people often need to tap into their retirement savings before the age of 59 ½. This can lead to non-qualified distributions from their Roth IRAs, and that means the distribution does not keep its tax-free characteristics. If you tap into your Roth IRA before the age of 59 ½ you’ll have to pay tax on the distribution. Maybe…
Because you received no tax benefits when you contributed money to your Roth IRA, you don’t have to pay tax on the contributed money when it comes out. This is similar to a bank account. I don’t get a tax break when I put money into my bank account, and I don’t pay taxes when I withdraw it from my bank account. It’s just my money. It is the same with the money you put into your Roth IRA.
The catch is this tax-free status is limited to the money you contribute to the account (which I am referring to as your tax basis). Any money that is in your Roth IRA due to growth (dividends, capital gains, interest, etc.) would be subject to taxes if withdrawn early. HOWEVER - when you make a withdrawal from your Roth IRA, the contributed money comes out first. So, you can take money out of your Roth IRA account up to the amount you contributed without a tax consequence. This can provide you with a valuable source of tax-free money if you need it in an emergency. Let’s look at an example.
Jimmy is 30 years old. Jimmy opens a Roth IRA and contributes $3,000 per year for 5 years. At the end of 5 years the Roth account has a value of $18,000. Jimmy contributed $15,000 and there is also $3,000 of growth in the account. Jimmy’s car was destroyed in a hurricane, and his insurance won’t pay for the loss. Jimmy needs a car, so he looks to his Roth IRA for money. Jimmy can take up to $15,000 out of his Roth IRA (the amount he contributed) and not have to pay any taxes on that withdrawal. If he takes more than $15,000 he will have to pay the taxes on the amount over $15,000, because that is from the growth of the investments in the account.
Knowing the amount of his basis in his Roth IRA was important to Jimmy. If he didn’t know how much he contributed he might have taken too large a distribution and given himself a tax problem for later. Or he may have been overly cautious and not withdrawn enough to buy reliable transportation, using a high-interest rate loan instead.
Jimmy’s basis was an easy number to know in my scenario. In real life it doesn’t normally work that way. In real life people are not quite as systematic. They put money in the Roth IRA when they can and don’t contribute when money is tight. After several years they aren’t really sure how much money they have contributed to their account. Which means they don’t know how much they can take out before they trigger a tax issue.
With a Roth IRA your bank or broker (whoever is holding your Roth IRA) may be able to help you determine your basis. If you’ve kept the account at the same bank or brokerage the entire time they may be able to provide you with a history of your contributions, as well as any previous withdrawals. If you’ve moved accounts, they may not have your full contribution history. It’s worth asking them, though.
I don’t advocate using your Roth IRA like a piggy bank. Just because you can take your contributed money out tax free does not mean you should. That account is designed to fund your retirement, and should not be used for anything else unless the need is great. But when the need is great, knowing your Roth IRA basis can be extremely useful knowledge.
Basis in Your Traditional IRA
The concept behind the Traditional IRA is you receive a tax benefit for contributing to the account, but you pay taxes on the money when it is withdrawn. This tax benefit is meant to encourage Americans to save for their retirement. Our government has decided, however, that not everyone needs to be provided with such an incentive. There are income limitations to claiming the tax benefits of contributing to a Traditional IRA. Those limitations change depending on whether your employer provides you with a retirement plan at work. If you have an employer-sponsored retirement plan (TSP, 401K, 403B, VRS, military pension, etc,) then you lose your right to claim the Traditional IRA tax benefit at a lower income level. If you do not have an employer-sponsored plan you are allowed to claim the Traditional IRA tax benefits until your income hits a higher level.
Note, these limitations are only on the tax break for contributing to the Traditional IRA. Regardless of your income level, you can always make contributions to your Traditional IRA, you just can’t always get the tax break for making the contribution. That’s how you start to form tax basis in your Traditional IRA - by making contributions that do not qualify for the tax break.
Just like the Roth IRA, any money you contribute to your Traditional IRA without getting a tax break for making the contribution can come out tax free. But - BIG DIFFERENCE ALERT - unlike the Roth IRA, your contributed money does not come out of your Traditional IRA first. Money distributed from your Traditional IRA comes out as a mix of qualified contributions, non-qualified contributions, and growth. You have to know the composition of that mix so you know how much of your withdrawal is taxable and how much is not taxable. Let’s look at another example.
Jane starts a Traditional IRA when she is 50 years old. She contributes $3,000 each year for 5 years, getting a tax break each year for those first 5 years. At age 55 Jane gets a promotion and a big pay raise at work. She increases her contributions to her Traditional IRA to $5,000 each year, but she is now unable to take the tax deduction for her contributions because her income is too high.
Jane is now 60 years old. Her Traditional IRA value is $60,000. Jane decides to take $10,000 from her Traditional IRA and go see New Zealand. How much of her withdrawal is taxable?
We know Jane’s taxable basis in her Traditional IRA is going to be the $25,000 (5 years times $5,000 per year) of contributions she made without getting a tax benefit. The $15,000 of qualified contributions and the $20,000 of growth in the account are all taxable. So, $25k/$60K (41.67%) is not taxable. $35,000/$60,000 (58.33%) of her $10,000 distribution (or $5,833) is taxable.
Again, my example is simple to make it easier to demonstrate the concept. Real life is rarely this clear. In real life people who have made contributions to their Traditional IRAs without receiving a tax break usually do not know what their tax basis is in their account.
What shocks many people is that their bank or brokerage can’t help them figure it out! Here’s why: whether or not you received a tax break for your Traditional IRA contribution is a function of whether your employer offers a retirement plan and your adjusted gross income - and your bank/brokerage doesn’t have that information! They don’t know which years your contributions received a tax benefit and which years they did not. When you take a distribution from a Traditional IRA the bank/brokerage will issue a form 1099-R, and they will check the box that says “Taxable Amount Not Determined”. It’s on you to determine the taxable amount and report it to the IRS when you file your tax return.
Figuring Your Traditional IRA Basis
Ideally, you’d be like Jane and track your Traditional IRA basis. But, what do you do if you’re like the 99.99% of Americans who have a basis in their Traditional IRA, but don’t know how much it is? If you’ve been filing your taxes correctly you can go back through your old tax returns and review your form 8606 submissions. You should have been reporting your non-deductible Traditional IRA contributions on this form each year.
If you don’t have all your old tax returns you can request tax return transcripts from the IRS. The transcripts are free, and you can use them to piece together the information you need to determine your Traditional IRA basis in that way.
If you want help determining your basis in your IRA come see me. I have a nifty tool that can pull all your IRS transcripts going back to 1990. We can pull all your transcripts at once and cull them for the information we need.