Does Cost Basis Matter in an IRA? Pro-Rata Rule and Form 8606

Cost basis in an IRA matters in one sense and not in another, and the distinction is worth getting straight before you file anything. The purchase price of the stocks, funds, or bonds you trade inside the account has no effect on your federal taxes. But the total after-tax money you’ve contributed to an IRA is a separate kind of basis, and losing track of it can mean paying tax on the same dollars twice.

Trading Inside an IRA Doesn’t Create Taxable Events

In a regular brokerage account, every sale triggers a capital gains calculation, and you report those gains or losses on Form 8949 and Schedule D.¹ An IRA skips all of that. The account is tax-exempt under federal law, so the IRS doesn’t care what happens between the investments held inside it.²

A Traditional IRA defers all taxes until you take money out. You can rebalance, harvest winners, and dump losers hundreds of times a year without generating a single taxable event. When you finally withdraw, the custodian reports the gross distribution on Form 1099-R and the IRS taxes it as ordinary income.³ Whether the money came from a stock you bought at $10 and sold at $100, or the reverse, the tax treatment is identical.

A Roth IRA goes further. Contributions are made with after-tax dollars, and qualified distributions are completely tax-free.⁴ A fund that triples inside a Roth generates zero capital gains tax, ever. The purchase price of any asset inside either account is a number your brokerage tracks for your own reference, not something the IRS needs.

When After-Tax Contributions Create Real Basis

Basis in an IRA takes on real financial stakes when you make a non-deductible contribution to a Traditional IRA. That money has already been taxed once. The cumulative total of those after-tax contributions becomes your cost basis in the account, and tracking it is the only way to avoid paying tax on the same money again when you eventually withdraw it.⁵

Non-deductible contributions typically happen when your income is too high to deduct a Traditional IRA contribution. For 2026, the IRA contribution limit is $7,500, or $8,600 if you’re 50 or older.⁶ Anyone with earned income can contribute up to that amount, but the deduction phases out based on your modified adjusted gross income if you or your spouse are covered by a workplace retirement plan. Once you’re past the phase-out range, the contribution is non-deductible: no upfront tax break, but the money still grows tax-deferred.

Consider what happens without records. If you contributed $5,000 in after-tax dollars for 15 years, you’ve built up $75,000 in basis. Without documentation proving those contributions were non-deductible, the IRS treats every dollar you withdraw as taxable ordinary income. That’s $75,000 taxed twice.

How the Pro-Rata Rule Splits Every Withdrawal

You can’t cherry-pick which dollars come out of a Traditional IRA. Federal law treats all your Traditional, SEP, and SIMPLE IRAs as a single pool for tax purposes, and every distribution comes out as a proportional mix of pre-tax and after-tax money under what’s called the pro-rata rule.²

The math is straightforward. Divide your total non-deductible basis by the combined year-end value of all your Traditional, SEP, and SIMPLE IRAs. That gives you the percentage of any distribution that comes out tax-free. The IRS uses the December 31 value of the year in which you take the distribution.⁷

Say you have $40,000 in non-deductible basis and your combined Traditional IRA balances total $400,000 on December 31. Your non-taxable percentage is 10%. Withdraw $20,000, and only $2,000 is tax-free (the return of basis). The remaining $18,000 is taxable ordinary income. That ratio applies regardless of which IRA account you pulled from or which investments you sold to fund the withdrawal.

The aggregation catches people off guard. Even if you keep your non-deductible contributions in a separate IRA from a rollover IRA, the IRS lumps them together for this calculation. A large rollover IRA full of pre-tax money dilutes the tax-free percentage of every withdrawal you take.

Roth Basis and the Order of Withdrawals

Roth IRAs have their own version of basis, and it matters in a different way. Your Roth basis is the total amount you’ve contributed with after-tax dollars over the life of the account. That money can always be withdrawn tax-free and penalty-free, at any age, for any reason, with no waiting period. It’s one of the most valuable features of a Roth.

The IRS enforces a strict ordering rule for Roth withdrawals.⁸ Regular contributions come out first, always tax-free and penalty-free. Conversion amounts come out second, on a first-in, first-out basis, with the portion that was taxable at conversion coming out before any non-taxable portion. Earnings come out last, only after all contributions and conversions are exhausted.

That ordering protects most Roth owners from unexpected taxes on casual withdrawals, since contributions are always the first dollars out. Trouble starts when you dip into conversion amounts or earnings before meeting the requirements for a qualified distribution. Each Roth conversion carries its own five-year holding period. If you withdraw converted amounts before that conversion’s five-year clock expires and you’re under 59½, the pre-tax portion of the conversion is hit with a 10% early withdrawal penalty.⁹ Earnings withdrawn before you turn 59½, or before the five-year period for your first Roth contribution is complete, face both ordinary income tax and the 10% penalty.⁴

Knowing your exact Roth contribution basis tells you how much you can pull out at any time without tax consequences. Lose track of that number, and you might report a tax-free withdrawal of contributions as a taxable withdrawal of earnings.

Form 8606 Is How You Prove Your Basis

The IRS does not track your non-deductible IRA basis for you. That responsibility falls on you, and the tool is Form 8606, “Nondeductible IRAs.” File it with your tax return in any year you make a non-deductible Traditional IRA contribution.¹⁰ File it again in any year you take a distribution from a Traditional IRA that contains basis, because the form is where you calculate the pro-rata split between taxable and non-taxable portions.⁷

Part I of the form records your current-year non-deductible contribution and carries forward the running total of your cumulative basis. Part II handles the pro-rata calculation when you take a distribution, using the December 31 value of all your Traditional, SEP, and SIMPLE IRAs. The form creates the paper trail that proves to the IRS which dollars have already been taxed.

Skipping Form 8606 is one of the most common and costly IRA mistakes. Without it, you have no documentation that your contributions were after-tax, and the IRS can treat every dollar distributed as fully taxable. The statutory penalty for failing to file is $50 per form, with an exception for reasonable cause.¹¹ The $50 penalty is trivial compared to the real cost: losing the ability to prove your basis.

Fixing Missed Filings

If you forgot to file Form 8606 in prior years, you can still fix it. The safest approach is to file an amended return (Form 1040-X) for each missed year, attaching the Form 8606 that should have been included. Some tax professionals take a lighter approach and mail a standalone Form 8606 for the missed year with a cover letter explaining the oversight. Either way, reconstruct your contribution history using old tax returns, Form 5498 statements from your custodian (which show annual contributions), and any account records you kept. The longer you wait, the harder this gets.

Records to Keep

The IRS instructs taxpayers to hold on to certain documents until every dollar has been distributed from all IRAs, including Roth IRAs:¹²

Page 1 of your Form 1040 for every year you made a non-deductible contribution
Every Form 8606 you’ve ever filed, along with any supporting worksheets
Form 5498 statements from your IRA custodian, showing annual contributions and year-end account values
Form 1099-R statements for every year you received a distribution

That is potentially a lifetime’s worth of records. Digital copies are fine, but they need to live somewhere you can still access decades from now. Losing these documents doesn’t change what you owe. It destroys your ability to prove what you don’t owe.

Basis Carries Over Through Inheritance and Divorce

When someone inherits a Traditional IRA that contains non-deductible basis, that basis transfers to the beneficiary. The beneficiary isn’t taxed on the after-tax portion, but they need to know it exists in order to claim the exclusion, and they file their own Form 8606 when taking distributions.¹² If the original account owner never tracked basis, the beneficiary inherits a tax problem along with the account. If you have non-deductible contributions, make sure your beneficiaries know the basis exists and where the documentation is.

When an IRA is transferred between spouses or former spouses as part of a divorce, the transfer itself is tax-free. The receiving spouse takes over the transferor’s basis; federal law treats the transfer as a gift, and the recipient steps into the original owner’s tax position, including any non-deductible basis.¹³ The basis doesn’t reset. If your former spouse had $30,000 in non-deductible basis and transfers the IRA to you, you inherit that $30,000 basis and should file Form 8606 accordingly.

Losses Inside an IRA Are Not Deductible

Before 2018, taxpayers who closed out all their Roth IRAs (or all Traditional IRAs with basis) for less than their total contributions could claim the shortfall as a miscellaneous itemized deduction on Schedule A. That deduction no longer exists. The Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions subject to the 2% floor for tax years 2018 through 2025, and the provision has been extended.¹⁴

If your IRA investments lose money, you absorb the loss. There is no mechanism to deduct it. That’s the flip side of tax-free growth: gains inside an IRA are never taxed as capital gains, but losses can’t offset other income either. Over a full career of compounding, the trade-off overwhelmingly favors the investor, but don’t assume an IRA loss is recoverable at tax time.

1
Internal Revenue Service. Instructions for Form 8949
2
Office of the Law Revision Counsel. 26 USC 408 – Individual Retirement Accounts
3
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
4
GovInfo. 26 USC 408A – Roth IRAs
5
Internal Revenue Service. Publication 590-A (2025), Contributions to Individual Retirement Arrangements (IRAs)
6
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026; IRA Limit Increases to $7,500
7
Internal Revenue Service. Publication 590-B (2025), Distributions from Individual Retirement Arrangements (IRAs)
8
eCFR. 26 CFR 1.408A-6 – Distributions
9
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
10
Internal Revenue Service. About Form 8606, Nondeductible IRAs
11
Office of the Law Revision Counsel. 26 USC 6693 – Failure to Provide Reports on Individual Retirement Accounts or Annuities
12
Internal Revenue Service. Instructions for Form 8606 – Nondeductible IRAs
13
Office of the Law Revision Counsel. 26 USC 1041 – Transfers of Property Between Spouses or Incident to Divorce
14
Internal Revenue Service. Tax Cuts and Jobs Act – Individuals