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What Does Basis Mean?
You might hear the term 'basis' thrown around in finance with different meanings, but I want to focus on how it most often points to the difference between prices and expenses in transactions, especially when you're figuring out taxes. This ties directly into concepts like cost basis or tax basis, and it's key when you're calculating capital gains or losses for your income tax returns.
Key Takeaways
- In finance, basis generally means the expenses or total costs tied to an investment.
- It can also refer to the difference between an asset's spot price and the price of its related derivative futures contract.
- Basis carries major tax implications since it captures the costs linked to a product.
- In another sense, basis is the variation between a deliverable commodity's spot price and the futures contract's relative price, or simply a security's purchase price after adding commissions or other expenses.
Basis in the Futures Market
Let me explain basis in the futures market: it's the difference between the cash price of a commodity and the futures price for that same commodity. If you're a portfolio manager or trader, you need to understand this because the interplay between cash and futures prices directly affects the value of hedging contracts. That said, the concept can get a bit unclear at times—there are often gaps between the spot price and the relative price right up until the nearest contract expires, so the basis isn't always spot-on accurate.
Beyond just the time gaps from contract expiry to the spot commodity, you might see other variations due to factors like actual delivery details, differences in product quality, or even delivery locations. Overall, investors like you use basis to assess the profitability of delivering cash or the actual commodity, and it's also a tool for spotting arbitrage opportunities.
Basis as Cost
When we talk about basis as cost, it's straightforward: for a security, it's the purchase price after accounting for commissions or other expenses. You might know it as cost basis or tax basis, and it's what you use to calculate capital gains or losses when you sell. Take this example—suppose you buy 1,000 shares of stock at $7 each; your cost basis is the total $7,000 you paid.
Shifting to IRAs, basis comes from nondeductible contributions and rollovers of after-tax amounts. Earnings on these are tax-deferred, just like with deductible contributions or pre-tax rollovers. When you take distributions of basis amounts from an IRA, they're tax-free. But to make sure you get that tax-free treatment, you have to file IRS Form 8606 every year you add basis to the IRA and every year you make distributions from any traditional, SEP, or SIMPLE IRAs.
If you skip filing Form 8606, you could end up with double taxation on those amounts plus a $50 penalty from the IRS. Here's an example: say your IRA is worth $100,000, and $20,000 of that is from nondeductible contributions, making up 20% of the total. That ratio applies to withdrawals, so if you pull out $40,000, 20% or $8,000 is basis and isn't taxed.
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