Basis of Assets Distributed from a Roth IRA

A simple answer to a complex question

[NOTE: This is a test of a new shorter-form article format, designed to take smaller bites from complex topics. If you like this format, please let me know.]

Intro, and Supporting This Article

I had the privilege of tagging along with Paul Hood recently to present a webinar for Leimberg Information Services on Handling the Elephant IRA: Large Balances, Big Challenges, Smart Solutions. (As an aside if you are not a newsletter subscriber but would like to support me, please consider purchasing our webinar by clicking here.)

In the wake of this webinar in which we discussed (as somewhat of a spoiler) whether it always makes sense to keep a Roth IRA intact, I received an interesting question from an attendee who had clients with significant Roth balances – mostly in real estate. The question related to the basis of property distributed in-kind from a Roth. If you know the answer off the top of your head, kudos to you - you can stop reading.

If not, we will explore some technical questions before arriving at the final answer. But, this topic should be of special interest to those who have, or deal with, large or illiquid Roth balances.

Why Distribute In-Kind?

For any qualifying IRA, there is no income tax at the IRA level. So, basis seems like somewhat of a moot point. If you know much about tax law, however, you may draw a parallel to analogous situations involving other forms of entities under which we might end up between two bounds – the lower bound (assuming property is appreciated) being a carryover basis, and the upper bound being the fair market value of the property.

Usually, however, the upper bound – FMV – would mean that some income tax is incurred by the distributee in connection with the distribution. That would seem to be the case with a traditional IRA, as any distribution is taxed to the distributee (with any “basis” in the IRA – created from non-deductible contributions – not being taxed since it is a return on the investment in the contract). This logic on fair market value, however, does not appear at first glance to extend to a Roth IRA since “qualified distributions” are not taxed to the distributee under IRC Section 408A(d).

In determining a qualified distribution, there are special rules around aging of contributions for 5 years, time of distribution, elections by beneficiaries, and even source (as related to rollover contributions). These rules are best left, however, for a subsequent article.

While the answer to this question is not found in the Code, the Treasury Regulations for IRC Section 408A – along with IRS Publication 590-B – both confirm the following:

The basis of any property distributed from a Roth IRA – even if it is not a qualified distribution – will be the fair market value of the property at the time of distribution.

Source Analysis

In July 2024, updated Treasury Regulations were published which replaced (wholesale) many of the pre-SECURE Act rules interpreting distribution requirements from IRAs and qualified plans. What have not yet been replaced, however, are the rules dealing with Roth IRAs. The most recent changes clarify that there are no required minimum distribution requirements during the owner’s lifetime, and that the owner will be treated as having died before their required beginning date (for purposes of then applying the minimum distribution rules to the Roth IRA beneficiaries).

In longstanding Treas. Reg. 1.408A-6, Q&A-16, we find an answer that is as plain and straightforward as one could hope for:

Q-16. How is the basis of property distributed from a Roth IRA determined for purposes of a subsequent disposition?

A-16. The basis of property distributed from a Roth IRA is its fair market value (FMV) on the date of distribution, whether or not the distribution is a qualified distribution. Thus, for example, if a distribution consists of a share of stock in XYZ Corp. with an FMV of $40.00 on the date of distribution, for purposes of determining gain or loss on the subsequent sale of the share of XYZ Corp. stock, it has a basis of $40.00.

Conclusion

There isn’t much to add, hence why this topic is appropriate for a short-form article. Note however that this only applies to a Roth IRA. It does not answer the question for a traditional IRA or qualified plan. Why might we care in either scenario if, for example, the IRA or qualified plan could simply liquidate the asset and distribute cash? After all, cash is king.

The problem arises where illiquid assets are held. Without belaboring the issues with self-dealing or prohibited transactions, it may not be possible for the IRA to quickly liquidate certain assets when compared to publicly-traded securities. And, there may be compelling reasons (such as creditor protection) to keep a Roth IRA intact both during the owner’s life and after their death. But, this runs headlong into minimum distribution rules which means the IRA custodian may be stuck with obtaining a valuation for illiquid assets that might then have to be distributed fractionally depending on the type of beneficiary.

This also raises the question of whether valuation discounts might be available or, alternatively, might be forced. If discounts are available, perhaps the owner or beneficiary (if an individual is directly named as beneficiary) could better benefit from personally utilizing such discounts for transfer tax purposes. Given that there is already a “synthetic” step-up in basis for distributions of property in-kind from a Roth (coupled with no income tax so long as it is a qualified distribution), might these assets be great candidates for lifetime gifts?

Stay tuned, as we will further explore these issues in subsequent articles as relates to qualified plans, traditional IRAs, ESOPs, and strategies such as net unrealized appreciation and rollover-as-a-business-startup (ROBS) arrangements.

And, if you would like to support me, please consider purchasing the webinar that Paul Hood and I presented on elephant IRAs. Here is the link.