3672 / Why is IRA basis important in determining the tax treatment of IRA distributions?

When clients think of IRA contribution limits, they generally think of the amount that the client may contribute and deduct from income (i.e., $7,000 in 2025 (projected), $7,000 in 2024 and $6,500 in 2023, with a $1,000 catch-up provision for clients aged 50 and older). However, deductions are limited for those individuals whose income exceeds the annual inflation-adjusted thresholds.

As a result, a taxpayer may make nondeductible contributions to an IRA even when his or her income is too high to qualify for a tax deduction. These nondeductible contributions represent the “basis” in the IRA, and are withdrawn tax-free (unlike traditional, deductible contributions, which are taxed under the general rules upon distribution). After-tax funds that are rolled over from another retirement account will also be added to the account’s basis.

The Tax Court recently found that the bulk of a lump sum distribution received by a taxpayer was taxable even though the taxpayer was a high-income taxpayer who would have been unable to deduct his IRA contributions. This is because the taxpayer was unable to produce documents that would prove the value of his basis in the account. Instead, the court relied upon Forms 5498 (Individual Retirement Arrangement Contribution Information) with respect to the taxpayer to limit his non-taxable distribution to the amount of nondeductible contributions that could be proven.¹