Taxability of IRA Distributions

 

The taxability of IRA distributions is very complex. There are a number of different types of IRAS and a wide variety of circumstances within which distributions can occur. There may also be a variety of penalty taxes applicable in certain cases.

The information presented below is primarily the view of the IRS as of early 1998. However, statutes and IRS interpretations change frequently, so it is important to contact a qualified professional regarding the facts and circumstances of your individual situation. Contact us for assistance in your individual case.

In general, include IRA distributions in your gross income in the year you receive them.

Exceptions to this general rule are rollovers and timely withdrawals of contributions, discussed earlier, and the return of nondeductible contributions, discussed next under Distributions Fully or Partly Taxable. Distributions, including rollovers, are also discussed under Savings Incentive Match Plan for Employees (SIMPLE), later. Distributions from Roth IRAs may also be exempt.

Ordinary income. IRA distributions that you must include in income are taxed as ordinary income.

No special treatment. In figuring your tax, you cannot use the special averaging or capital gain treatment that applies to lump-sum distributions from qualified employer plans.

Distributions Fully or Partly Taxable

Your IRA distributions may be fully or partly taxable, depending on whether your IRA includes any nondeductible contributions.

Fully taxable. If only deductible contributions were made to your IRA (or IRAs, if you have more than one) since it was set up, you have no basis in your IRA. Because you have no basis in your IRA, any distributions are fully taxable when received. See Reporting and Withholding Requirements for Taxable Amounts, later.

Partly taxable. If you made nondeductible contributions to any of your IRAs, you have a cost basis (investment in the contract) equal to the amount of those contributions. These nondeductible contributions are not taxed when they are distributed to you. They are a return of your investment in your IRA.

When IRA distributions are made, special rules apply in figuring the tax on the distributions if:

Only the part of the distribution that represents nondeductible contributions (your cost basis) is tax free. Once nondeductible contributions have been made, distributions consist partly of nondeductible contributions (basis) and partly of deductible contributions, earnings, or gains. Until you run out of basis, each distribution is partly taxable and partly nontaxable.

Form 8606. You must complete, and attach to your return, Form 8606 if you receive an IRA distribution and have ever made nondeductible IRA contributions. Using the form, you will figure the nontaxable distributions for 1997, and your total IRA basis for 1997 and earlier years. See the illustrated Forms 8606 in Appendix D.

Note: If you are required to file Form 8606, but you are not required to file an income tax return, you still must file Form 8606. Send it to the IRS at the time and place you would otherwise file an income tax return.

Figuring the Nontaxable and Taxable Amounts

If your IRA includes nondeductible contributions and you received a distribution from it , you must use Form 8606 to figure how much of your  IRA distribution is tax free. See the instructions for the correct year's form for information on how to make the calculation.

Recognizing Losses on IRA Investments

If you have a loss on your IRA investment, you can recognize the loss on your income tax return, but only when all the amounts in all your IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2% limit, on Schedule A, Form 1040.

Inherited IRAs

The beneficiaries of your IRA must include distributions to them in their gross incomes. Inherited IRAs have complex rules and the notes below are generic advice. However, there may be a number of elections available in your particular case that could significantly reduce your taxes or delay the date when you need to start taking distributions.

Beneficiaries. Your beneficiaries can be your estate, dependents, and anyone you choose to receive the benefits of your IRA after you die.

Spouse. If you inherit an interest in an IRA from your spouse, you can elect to treat the entire inherited interest as your own IRA. Seek professional assistance before making this election.

Beneficiary other than spouse. If you inherit an IRA from someone other than your spouse, you cannot treat it as though you established it. The IRA cannot be rolled over into, or receive a rollover from, another IRA. No deduction will be allowed for amounts paid into that inherited IRA, nor can nondeductible contributions be made to an inherited IRA. [The above is the IRS's position and is not settled law, contact your professional advisor if you have inherited an IRA].

IRA with basis. If you inherit an IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. Unless you are the decedent's spouse and choose to treat the IRA as your own, you cannot combine this basis with any basis you have in your own IRA(s) or any basis in IRA(s) you inherited from other decedents. If you take a distribution from an inherited IRA and your IRA, and each has basis, you must complete separate Forms 8606 to determine the taxable and nontaxable portions of those distributions.

Federal estate tax deduction. Your beneficiary may be able to claim a deduction for estate tax resulting from certain distributions from your IRA after you die. The beneficiary can deduct the part of the estate tax paid on any part of a distribution that the beneficiary must include in income as income in respect of a decedent. He or she can take the deduction for the tax year the beneficiary reports that income.

Any taxable part of a distribution that is not income in respect of a decedent is a payment the beneficiary must include in income. However, the beneficiary cannot take any estate tax deduction for this part.

If the beneficiary is your spouse, he or she can, as the surviving spouse, roll over the distribution to another IRA and avoid including it in income for the year received.

Other Special IRA Situations

There are other special IRA situations that you may encounter. Some examples include the following:

Distribution of an annuity contract from your IRA account. You can tell the trustee or custodian of your IRA account to use the amount in the account to buy an annuity contract for you. You are not taxed when you receive the annuity contract from your account. You are taxed when you start receiving payments from that annuity contract.

Tax treatment. If only deductible contributions were made to your IRA since it was set up (This includes all your IRAs, if you have more than one.), the annuity payments are fully taxable.

If your IRA includes both deductible and nondeductible contributions, the annuity payments are taxed as explained earlier under Distributions Fully or Partly Taxable.

Cashing in retirement bonds. When you cash in retirement bonds, you are taxed on the entire amount you receive. If you do not cash in your bonds before the end of the year in which you reach age 70 1/2, you will be taxed on the entire value of the bonds at that time. This is the amount you would have received if you had cashed in the bonds at that time. When the bonds are cashed later, you will not be taxed again.

Reporting and Withholding Requirements for Taxable Amounts

If you receive a distribution from your IRA, you will receive Form 1099-R, or a similar statement. IRA distributions are shown in Boxes 1 and 2 of Form 1099-R. A number or letter code in Box 7 tells you what type of distribution you received from your IRA.

The number codes are explained below.

The letter codes are explained below.

If the distribution shown on Form 1099-R is from your IRA, SEP-IRA, or SIMPLE IRA, the small box in box 7 (labeled IRA/SEP/SIMPLE) should be marked with an "X."

Withholding. Federal income tax is withheld from IRA distributions unless you choose not to have tax withheld.

The tax withheld from an annuity or a similar periodic payment is based on your marital status and the number of withholding allowances you claim on your withholding certificate (Form W-4P). If you have not filed a certificate, the tax withheld will be determined by treating you as a married individual claiming three withholding allowances.

Generally, tax will be withheld at a 10% rate on a nonperiodic distribution.

Withholding from IRA distributions delivered outside the United States. In general, if you are a U.S. citizen or resident alien and your home address is outside the United States or its possessions, you cannot choose exemption from withholding on your IRA distributions.

To choose exemption from withholding, you must certify to the payer under penalties of perjury that you are not a U.S. citizen, a resident alien of the United States, or a tax-avoidance expatriate.

Even if this election is made, the payer must withhold tax at the rates prescribed for nonresident aliens.

Reporting taxable distributions on your return. Report fully taxable distributions, including premature distributions, on line 15b, Form 1040 (no entry is required on line 15a), or line 10b, Form 1040A. If only part of the distribution is taxable, enter the total amount on line 15a, Form 1040 (or line 10a, Form 1040A), and the taxable part on line 15b (or 10b). You cannot report distributions on Form 1040EZ.

Estate tax. Generally, the value of an annuity or other payment receivable by any beneficiary of a decedent's IRA that represents the part of the purchase price contributed by the decedent (or by his or her former employer(s)), must be included in the decedent's gross estate. For more information, see the instructions for schedules I and S, Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.

 

Copyright 1999 Raymond S. Kulzick. All rights reserved. 991026.

This publication provides business, financial planning, and/or tax information to our clients. All material is for general information only and should not be acted upon without seeking appropriate professional assistance.

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Copyright 1999 Kulzick Associates, PA - Last modified: September 13, 2008