Cost basis is the standard method of determining how much money you put into an investment for tax purposes. Because IRAs operate under special tax rules, cost basis may not apply. When it does, you are supposed to report cost basis to the Internal Revenue Service. It is in your interest to do so, because there are tax benefits for reporting IRA cost basis.
Cost basis consists of all the deductible expenses you incur as part of an investment. For example, the cost basis for a stock investment includes the price paid for the stock and any transaction fees you pay when you buy and sell the shares. You subtract the cost basis from the total proceeds when you liquidate an investment to determine taxable income. However, for a traditional IRA, you don’t pay taxes on money in the account until you withdraw it. At that point, all of it is taxable, so there may be no cost basis at all. For Roth IRAs, cost basis isn’t used because all of the money properly withdrawn after you reach age 59 1/2 is tax-free.
Normally you can deduct all contributions to a traditional IRA when you file your income tax return. However, if you make more than the yearly limit set by the IRS you lose part or all of this deduction. You can still make nondeductible contributions to a traditional IRA up to the annual limit of $5,000 ($6,000 if you are 50 years old). Because you paid taxes on nondeductible contributions, they are not taxed a second time when you withdraw them once you retire – provided you report them using IRS form 8606. The total of all nondeductible contributions is referred to as your IRA cost basis. You subtract the cost basis before figuring taxes on disbursements from your IRA. If you do not report nondeductible contributions, the IRAs may treat them as taxable income.
The IRS treats nondeductible contributions to an IRA as an investment and a withdrawal simply as a return of invested funds. As a result, you can take all or part of your cost basis out of a traditional IRA before you reach age 59-1/2. Again, there is no tax liability. In addition, the 10-percent penalty tax normally imposed on early withdrawals from an IRA does not apply.
Many people choose to shift money from a traditional IRA toa Roth IRA at some point. There is no penalty for doing so as long as the “rollover funds” are deposited in the Roth account within 60 days of being removed from a traditional IRA. However, you must pay ordinary income taxes that would have been paid if you had waited until retirement age to take the money out of the traditional IRA. If you have reported nondeductible contributions you made to the traditional IRA, you have a cost basis that you can subtract from the rollover amount before the taxes are calculated.