When you sell stocks, real estate or other investments, you have to figure out how much of the sale proceeds are taxable as profit. Cost basis, also called tax basis, is a term used for the total amount of money you invested and is used as a steppingstone to figure your taxable profit. However, special tax rules apply to IRAs, and the concept of cost basis does not apply in the usual way.
Conventional Cost Basis
The cost basis of an investment consists of all expenses that are incurred from initial purchase to final sale. For example, the cost basis of a stock investment includes not just the purchase price of the shares, but also any broker’s commissions and transaction fees you pay to buy and sell the shares. To calculate the taxable profit, you subtract the cost basis from the total proceeds you receive for the sale of the investment assets.
IRA Cost Basis
With a traditional IRA and most other tax-advantaged retirement plans, your contributions are normally tax deductible. Nothing is taxed while funds stay in the IRA. When you pull the money out after you retire, everything is subject to income taxes. Most of the time, there isn’t any cost basis to calculate. However, people sometimes make nondeductible contributions to a traditional IRA. This usually happens when you make more than the IRS limit to qualify for the tax deduction, but choose to make contributions anyway. Because you’ve paid taxes on nondeductible contributions, they won’t be taxed again when you withdraw them. For tax purposes, the IRS calls nondeductible contributions to a traditional IRA your cost basis.
When you distribute (withdraw) money from the IRA after you retire, your cost basis (if any) is subtracted from the amount withdrawn before figuring taxes due. If you wish, you can even withdraw nondeductible contributions before you reach the minimum age of 59-1/2 without any penalty or tax liability. You are supposed to report all nondeductible contributions using IRS Form 8606, even if you don’t file an income tax return. If you don’t, the IRS will treat the cost basis amount as taxable income when you withdraw it.
The concept of cost basis does not apply to Roth IRAs. Contributions to a Roth IRA are not tax deductible and, as with traditional IRAs, funds are not taxed while they are in the account. However, the money you distribute from a Roth IRA after you retire is not subject to income taxes, so there is no need to keep track of a cost basis. If you roll over funds from another type of retirement account such as a traditional IRA, you normally have to pay the taxes on the money that you would have paid had you left the funds in the original account until you reached age 59-1/2. In this case, you need to calculate a cost basis on the rollover funds if you made any nondeductible contributions to the original account.