When I think of basis, I think of a partner’s basis in a partnership, but basis can also apply to individual retirement accounts. The general rule is that distributions from a traditional IRA are taxable. There is, however, an exception to this rule. If nondeductible contributions were ever made to the IRA, then not all amounts distributed would be taxable. This is when it becomes important to track the basis you have in your IRA. The cost basis of an IRA is the sum of any nondeductible contributions less any distributions of nondeductible contributions.
Form 8606, Nondeductible IRAs, is used to track the basis of a traditional IRA. This form should be filed every year that nondeductible contributions are made to a traditional IRA. The first year this form is filed, the total beginning basis is zero. For each year after that, you’ll need to refer to the Form 8606 filed in the prior year to determine the basis at the beginning of the current year. As nondeductible contributions are made, there is no tax impact; however, filing Form 8606 is important to later prove that distributions should not be fully taxable.
When distributions are taken from a traditional IRA, Form 8606 must be filed again. The calculations on this form will determine whether or not the distribution is taxable based on the basis in the traditional IRA. The key is to track your basis so you can be sure that distributions are properly treated as either taxable or nontaxable.