IRAs: Basics on Basis

It was recently suggested to me that members of the client centric team want to know a bit more about IRAs and the distribution rules associated with IRAs. In response to that inquiry, I thought I would begin a series of summaries over the next few weeks to address the IRA rules, admittedly on a pretty basic level. The IRA topics covered will be somewhat random, but if you want me to summarize some specific rules or distribution situations, please do not hesitate to contact me and I will spend some time trying to answer your questions.

Take-Away: While traditional IRAs generally have no income tax basis, and we often think of a Roth IRA as having an income tax basis equal to its account balance, following those generalities can often get you into trouble. When it comes to distributions from IRAs, traditional or Roth, nothing is really all that simple.

Background- Traditional IRAs: Most traditional IRAs are funded with pre-tax dollars, which means that there is no basis in that traditional IRA; most distributions will be taxed as ordinary income.

But we also know that some IRAs can receive after-tax dollars, which means that there is some income tax basis even in a traditional IRA account.

We also know that Roth IRAs are funded with after-tax dollars, which means that there is an income tax basis in a Roth IRA account.

These basic rules can become pretty complex, however, when traditional IRA accounts receive assets from other IRAs, or when after-tax contributed funds (i.e. some basis component) held in an employer’s qualified plan are rolled-out into the former participant’s traditional IRA.

Ordinary Income: When a traditional IRA holds after-tax contributions, i.e. basis, the earnings on those basis amounts are taxed deferred, not tax free. When those earnings on the basis amount are later distributed from the traditional IRA they are taxed as ordinary income to the IRA owner.
No Basis Step-Up: There is never a step-up in basis in a traditional IRA account [or any retirement account for that matter.]
Penalties: The earnings on the after-tax contributions held in the traditional IRA are also subject to the 10% excise tax if the distribution is made prior to the traditional IRA account owner attaining age 59.5 years.

Background- Roth IRAs: The earnings on a Roth IRA are usually income tax-free, but only if the distribution is a qualified distribution, which can often act as a trap for Roth IRA owners. Those owners are fully aware of the benefits of a Roth IRA, e.g. not subject to required minimum distribution rules; Roth earnings are not taxable, etc., but they often tend to overlook the requirement that the distribution from the Roth IRA must be a qualified distribution.

Qualified Distribution Required: To be a qualified distribution it must (i) be made more than five (5) years after the first Roth IRA account was established and (ii) be after the owner is age 59.5 years. If either the distribution is before the five years when a Roth IRA was established, or the Roth owner is not yet age 59.5 years, then the distribution will be taxable to the Roth owner. If I am age 64 but I created my Roth IRA only 4 years ago, any distribution that I take from my Roth IRA will be taxable, since while I was over the age 59.5 years, I had not established my Roth IRA for a minimum of at least 5 years. The 5 year rule is why some advisors suggest clients to open a Roth IRA, even with only a modest contribution, merely to start the 5 year clock running. Note that the owner must have established any Roth IRA for at least 5 years, not the Roth from which the distribution is to be taken.
3 Exceptions: Limited exceptions apply to the 5 year/age 59.5 limitations. Those exceptions permit a distribution from a Roth IRA for a first-time home purchase, or a distribution due to the Roth IRA owner’s disability or death.
Ordinary Income Taxation of Roth IRA: A non-qualified distribution from a Roth IRA will be subject to ordinary income taxation, and also the 10% excise tax if the Roth IRA owner is under age 59.5 years.

The Pro Rata or Cream in the Coffee Rule: Assume that you have a traditional IRA which holds some basis (after-tax) contributions. Distributions are taken from that traditional IRA. The IRS imposes a pro-rata rule to tax the distribution which contains some after-tax contributions. Each distribution from the traditional IRA will be partly pre-tax amounts, and partly after-tax amounts (meaning non-taxable.)

Note that different rules apply to a distribution from a qualified plan, e.g. a 401k account, and to a traditional IRA when the pro rata rule is applied. The qualified plan participant’s account balance is all that is looked at, even if the participant has multiple accounts established in multiple employer sponsored qualified plans. In contrast, all of the traditional IRA account owner’s IRAs are added together when applying the pro rata rule.

Example: I have three traditional IRA accounts and one SEP IRA account spread over four different IRA custodians- I like to keep them all guessing! The traditional IRA account balances are $75,000, $50,000, and $15,000. The SEP holds $90,000. The $15,000 traditional IRA account holds $12,000 of after-tax contributions that I made years ago. My intent is to draw $20,000 this year from any one of my traditional IRAs or my SEP IRA account. The pro rata rule requires that I aggregate all of my traditional and SEP IRA balances [$75,000+ $50,000 + $15,000 + $90,000 = $230,000.] The after-tax portion of that gross amount $12,000 divided by $230,000, which results in 5.2% tax-free component. Consequently, when I withdraw $20,000 from any one of my IRA accounts, $1,043 [5.2% of $230,000] will be income tax-free and $18,957 will be a taxable as ordinary income to me.

No Segregation: The Tax Code does not permit after-tax contributions to a traditional IRA to be segregated into their own IRA account. That would make life too easy for us. Rather, any after-tax contribution to any traditional IRA will cause the pro rata rule to be applied whenever a distribution is to be taken from any of the traditional IRA accounts.
End-of-Year Calculation: Yet another trap for traditional IRA owners who have to grapple with the pro rata rule is that the traditional IRA account balances against which the pro rata rule is applied are determined at the end of the calendar year during which the IRA distribution was taken, not the date on which the distribution actually occurred. There could be a wild swing in account balances between the date when the IRA distribution is taken and the end of the calendar year when the account balances are tallied, which is only when the tax-free portion of the IRA distribution can actually be identified.
Cream-in-the-Coffee Rule: The application of the pro rata rule has attracted the clever knick name of the cream in the coffee rule. Once cream is added to a cup of coffee, you cannot get just the cream out again. Each sip of the coffee is partly cream, partly coffee.

Roth IRA Distributions- First In, First Out Rule: While all Roth IRAs are treated as one account just like traditional IRAs, unlike distributions from a traditional IRA, the distributions from a Roth IRA are treated differently. The after-tax contributions to the Roth IRA are deemed to be distributed first (i.e. tax-free) to the owner before earnings are distributed from the Roth IRA- a first in, first out rule. But distributions from the Roth IRA must be qualified distributions to avoid income taxation.

Where Do You Report Basis: The individual IRA account owner has the responsibility to track the basis in their traditional IRA account. Any Roth IRA account owner who is under the age 59.5 years must track their basis in their Roth IRA, if they intend to take a distribution; once the 5 year/age 59.5 rules are satisfied, the Roth IRA owner no longer needs to track their basis in their Roth IRA. If the traditional IRA account owner has some basis in their distribution they must report that basis amount of the distribution on Form 8606 with their 1040 income tax return. Without this Form where the basis portion of the distribution can be identified by the IRS, the IRS will treat all IRA distributions as fully taxable ordinary income to the IRA owner, even when a portion of the distribution is a return of the owner’s after-tax basis contributions.