Generally, Traditional IRA accounts are funded with pre-tax dollars which, when distributed, would be treated as taxable income. However, there are certain instances where the IRA may have been fully or partially funded with after-tax dollars. This may occur by transferring after-tax money from certain retirement plans into the IRA or when a taxpayer makes an IRA contribution when their income exceeds certain limits making the contribution non-tax deductible.
It is important for taxpayers to keep good records of their “basis”, which is the after-tax portion of their IRAs, on Form 8606 so that they can apply their tax basis towards future distributions. Distributions from an IRA with a tax basis are considered to be proportionally split between basis and other income. The basis has already been taxed so it will reduce the amount of the total distribution that will be subject to taxes.
In addition, the basis of IRAs can pass to the beneficiaries, making it even more important to keep good records so that the beneficiaries can receive a tax-favored distribution in the future as well.
Failure to accurately track the tax basis of an IRA can cause those dollars to be erroneously taxed twice, which is a very negative outcome.