Recovery of cost basis in publication 551 the irs

Info icon This preview shows pages 62–64. Sign up to view the full content.

Recovery of Cost Basis In Publication 551, the IRS defines cost basis as the original cost paid for an item. The concept is that the original cost was paid for with money that has already been taxed once, and it would be counterproductive to tax it a second time. Cost basis, therefore, becomes an amount of money that is in an otherwise taxable situation that is not taxed. What might create a cost basis to accrue in a retirement account? There are two likely candidates. The first one is non-deductible contributions. Recall that non-deductible contributions are made from after- tax money. If they did not accrue as cost basis in a taxable account, then double taxation would occur. The second candidate is the cost of pure insurance that was included on an employee’s W-2 if they purchased a life insurance product within their employer-sponsored retirement account. There are four different distribution scenarios when cost basis will become very valuable. The first scenario is with a lump sum distribution that is not rolled over into an IRA. In this instance, the entire cost basis is recovered immediately. Consider a client with a 401(k) with a $150,000 balance and $25,000 of non-deductible contributions. This client would have $125,000 ($150,000 - $25,000) of taxable income in the year of the distribution. The next two scenarios both involve a rollover. In one rollover option, a client can roll over all deductible contributions as a first step. Their second step is to take a tax-free distribution of all non-deductible contributions to recapture their cost basis all at once. Consider the client with $150,000 in a 401(k) and
Image of page 62

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

$25,000 of cost basis. They could elect to roll $125,000 into a traditional IRA and then receive a $25,000 tax-free distribution. The second rollover option is to roll all assets, both deductible, and non-deductible contributions, into a traditional IRA. Again, consider our client with a $150,000 balance in their 401(k) and a $25,000 cost basis. If they roll the entire $150,000 into a traditional IRA, then they will need to calculate a pro-rated cost basis recovery every time they take a distribution. Let’s further assume that this client already has a second IRA with a $100,000 balance. The client keeps both IRAs separate and decides to take a $10,000 distribution from their recently rolled over IRA. Their pro-rata cost basis recovery is factored using the formula below. Applying this pro-rata cost basis formula, we find that the actual dollar amount of pro-rata cost basis recovery will be $1,000 ($10,000 x [$25,000 / $250,000]). This means that the $10,000 distribution will result in $9,000 of taxable income and $1,000 of tax-free cost basis recovery. The remaining cost basis in the IRA is now $24,000 ($25,000 - $1,000). This number will become the numerator for the pro-rata cost basis recovery calculation next time a distribution is needed. The important note to this process is that the denominator in this equation ($250,000) must include all traditional IRAs owned by this taxpayer.
Image of page 63
Image of page 64
This is the end of the preview. Sign up to access the rest of the document.
  • Spring '14
  • VOSS,JAMESA
  • Cash balance plan

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern