IRA Distributions

A distribution is a transfer of money or property from an Individual Retirement Account (IRA) account to the taxpayer. The distribution rules for tax-deferred accounts are complex, but the same rules apply to the 3 types of IRA accounts that defer taxes on contributions: traditional IRAs, SIMPLE IRAs, and SEP-IRAs. Different rules apply to Roth IRAs since contributions have already been taxed, so distributions from Roth IRAs are tax-free. The rules for tax-deferred IRA accounts are easier to understand if the objectives of the rules are understood:

• distributions are taxable when received;
• so that the government receives it share of the money, there are required minimum distributions after reaching age 73;
• to enforce the main objective of retirement accounts, which is to provide for retirement, there are tax penalties for early distributions;
• if the taxpayer dies before receiving all distributions from all his IRA accounts, then the remaining value in those accounts passes to beneficiaries, who are also subject to special rules for distributions.

Since the distribution rules are the same for all tax-deferred IRA accounts, this article will focus on discussing the traditional IRA, which is the most common type of account.

Although distributions are a transfer of money or property from the account to the account holder, some transactions are also considered distributions. A conversion of a traditional IRA to a Roth IRA is considered a distribution that must be added to income then. Pledging the account as collateral for a loan is treated as a taxable distribution. When an IRA account is garnished, such as when child support obligations are enforced, the garnishment is considered a distribution the taxpayer must include in income. If the distribution is not a qualified distribution, then the 10% tax penalty also applies. Garnishment is treated as a distribution because it discharges an indebtedness of the taxpayer.

Distributions from traditional IRAs are taxable and are reported on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc.. The custodian may withhold federal tax, but the taxpayer can direct the custodian not to withhold federal taxes by using Form W-4P.

Determining the Allocation of Nondeductible Contributions to a Distribution

Unlike a Roth IRA, distributions from a traditional IRA are generally taxable. However, if the taxpayer made nondeductible contributions, then that portion is tax-free. To determine the taxable and nontaxable portion of the distribution, the taxpayer must file Form 8606, Nondeductible IRAs, even if the taxpayer withdraws money only from an account that had no nondeductible contributions. The allocation between taxable and nontaxable portions must still be made since all IRA accounts are treated as one contract. Hence, the taxpayer does not have the freedom to choose whether a distribution is from nondeductible contributions or not. If the taxpayer never made any nondeductible contributions, then the entire distribution is fully taxable.

Payments from an individual retirement annuity are also fully taxable. Distributions from an endowment policy have taxable and nontaxable portions. The distribution allocable to retirement savings is taxable, whereas the portion allocable to the life insurance is treated as insurance proceeds, which are not taxable.

To track nondeductible contributions, the taxpayer should retain all copies of Forms 8606 for which non-deductible contributions were recorded, Forms 5498, IRA Contribution Information that show all IRA contributions and the value of the IRAs at the end of each year in which a distribution was made, and all Forms 1099-R and Forms W-2P, Statement for Recipients of Annuities, Pensions, Retired Pay, or IRA Payments showing IRA distributions. These records should be kept until all the funds in all IRA accounts have been distributed.

The general steps required to determine the taxable and tax-free portions of an IRA distribution:

If the taxpayer is a beneficiary of 1 or more IRAs, then the taxable and nontaxable portions of distributions from each IRA must be calculated separately, based on the tax basis of each separate account.

Divorce

If an IRA is transferred to a spouse or former spouse because of a decree of divorce or separate maintenance, then the transfer is not treated as a taxable distribution if the money is transferred directly or if the name of the IRA account is simply changed to the name of the receiving spouse. However, if the distribution is withdrawn from the IRA and transferred to the spouse, then it will be treated as taxable income to the withdrawing spouse. Any benefits received from an employer plan of a spouse or former spouse pursuant to a qualified domestic relations order (QDRO) will be taxable unless the distribution is rolled over to an IRA or other eligible retirement plan.

10% Tax Penalty for Early Distributions

A 10% tax penalty must be paid for early distributions, which is a distribution received before age 59½ except when:

• the distribution was rolled over,
• the taxpayer became totally disabled,
• the distribution was used to pay:
  • medical expenses exceeding the medical-expense AGI floor (7.5% of adjusted gross income)
    • For the medical expense exception to apply, the expenses must be eligible for the itemized medical deduction, even if the taxpayer claims the standard deduction instead of itemizing, but only the distribution amount exceeding 7.5% of AGI after including the taxable IRA distribution is tax-free. Further, the expenses must be paid in the same year as the distribution.
  • medical insurance premiums while receiving unemployment compensation for at least 12 consecutive weeks,
    • Self-employed taxpayers can qualify if unemployed for 12 weeks, even though they do not qualify for unemployment benefits.
  • qualified higher education expenses,
    • For the qualified higher educational expenses exception to apply, the qualified educational expenses must be paid in the same year of the distribution.
  • for the legal adoption or the birth of a child, not exceeding $5,000:
    • funds must be withdrawn within 1 year of the adoption or before the baby’s 1^st birthday
  • an emergency personal expense, not exceeding $1000, for an unforeseeable or immediate financial need to pay necessary personal or financial emergency expenses for medical care, accidents, funeral expenses, and auto repairs, or to prevent imminent foreclosure or eviction from your home
• the distribution, not exceeding $10,000, was used to buy a 1^st home,
  • A first-time homebuyer is one who did not have an ownership interest in a principal residence during the 2-year period preceding the purchase of a new home. If the taxpayer is married, then the same rule applies to the spouse.
• the distribution was to a
  • victim of domestic abuse, not exceeding the lower of $10,000 or 50% of the present value of the vested benefit under the plan
  • beneficiary of an IRA of a deceased owner,
    • But if a spouse treats the IRA of a deceased spouse as her own, then early distributions will be subject to the 10% tax penalty.
  • taxpayer living in a federally declared disaster area
    • The distribution, up to $22,000, is taxable but not subject to the 10% penalty.
    • The distribution can be recontributed within 3 years.
    • The taxes paid on the distribution can be recouped by filing an amended return.
• the distribution was because of an IRS levy,
• the distribution is one of a series of payments made as an annuity, or
• the distribution was a qualified reservist distribution.

If the taxpayer qualifies for an exception, the IRA custodian may show the exception on Form 1099-R. But if the custodian does not know of the exception, then no code will be listed, in which case the taxpayer must file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax Favored Accounts to claim the exemption. A rollover need not be reported on Form 5329.

The 10% early distribution penalty can be avoided if distributions are received as annuity payments. However, the payments must continue for the longer of 5 years or until the taxpayer reaches 59½.

Required Minimum Distributions (RMDs)

Since contributions to a traditional IRA are tax deductible, and the earnings grow tax-free, the federal government wants to tax the money eventually, so the taxpayer must start receiving required minimum distributions (RMDs) by age 73, even if the taxpayer continues to be employed. The 1^st distribution must be received by April 1 of the year after the year when the taxpayer reaches 73. However, it is generally better to take this distribution when reaching age 73 since waiting until the next year will require 2 distributions for that year, for which a higher applicable marginal tax rate may apply. Thereafter, annual distributions must be received by year-end.

If the distribution is less than the RMD, then a 25% excise tax penalty will be assessed on the difference unless there was a reasonable cause for the shortfall. The 25% penalty is reduced to 10% if the insufficient distributions are corrected within 2 years, defined in final regulations as the last day of the 2^nd taxable year after the year when the excise tax applies and by filing Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts and attaching a statement explaining that a reasonable error caused the underpayment and that you have or will correct the shortfall.

For more details on RMDs, see Required Minimum Distributions (RMDs).

Distributions from Individual Retirement Annuities

Distributions as an annuity can be 1 of 3 methods approved by the IRS:

1. required minimum distribution method
2. fixed amortization method
3. fixed annuitization method.

All payments allocable to tax-deductible contributions will be taxed, and the payments must continue for a minimum number of years, equal to the lesser of 5 years or until the taxpayer reaches age 59½; otherwise a 10% tax penalty + interest will be applied retroactively to all taxable payments received before age 59½, unless the taxpayer becomes totally disabled or the payments are to beneficiaries of a deceased IRA owner.

The scheduled arrangement of payments cannot be changed unless the taxpayer becomes disabled. However, when an IRA is divided because of divorce or separation, the IRS allows a reduction in the payment schedule if part of the IRA is transferred to the ex-spouse as part of the divorce or separation settlement.

The IRS also allows a 1-time irrevocable switch from a fixed amortization method or fixed annuitization method to the RMD method. After the minimum payout period, the payment schedule can be changed without penalty or the payments can even be discontinued.

Under any of the approved methods, the taxpayer must receive at least 1 distribution annually. Under the RMD method, the payment is determined annually by the value in the account. Under the other methods, the annual payment is fixed, but the IRS, in private letter rulings, has allowed the payment schedules to be recalculated each year. Taxpayers using the non-RMD methods can also reduce the required annual amount without penalty by switching to the RMD method. All the methods are based on the taxpayer's life expectancy and a beneficiary 10 years younger or by the joint life and last survivor expectancy of the taxpayer and his spouse.

The annual distribution from the RMD method is figured by dividing the account balance by the taxpayer's life expectancy or by the joint life expectancy, which are based on IRS tables published in Publication 590. So if the IRA account balance = $1,000,000 and the taxpayer has a 25 year life expectancy, then the minimum 1^st distribution is calculated by dividing 1,000,000 by 25, or $40,000. The 2^nd year distribution = the account balance on the previous year-end divided by 24, etc. Payments based on the joint life and last survivor expectancy will always be smaller since a joint life expectancy is always longer than for 1 person.

The fixed amortization method amortizes the IRA account balance, in which the payments eventually reduce the account balance to 0. The payment amounts depends on the interest rate used to calculate the amortization.

Under the fixed annuitization method, an annuity factor, calculated from a mortality table published in Revenue Ruling 2002-62, is used to determine the payment. Payments under both the fixed amortization method and fixed annuitization method depend on the interest rate used in the calculations, but the maximum interest rate cannot exceed 120% of the federal midterm rate for either of the 2 months preceding the 1^st distribution. A tax professional will be needed to calculate the RMD using the non-RMD methods.

Qualified Charitable Distributions

Taxpayers who are at least 70½ may donate cash, up to a certain inflation-adjusted limit, directly from their IRAs to qualified charities. The taxpayer must be at least 70½ when the QCD is made; this age requirement is lower than the 73-year age requirement for RMDs. These qualified charitable distributions (QCDs) are tax-free to the taxpayer and are counted for RMDs. Furthermore, this tax benefit for a charitable contribution does not require itemizing deductions. The QCD also does not count as income for the Income-Related Monthly Adjustment Amount (IRMAA) for Medicare that is used to determine whether the taxpayer should pay higher Medicare premiums based on income.

However, choosing the QCD income exclusion means that it cannot also be deducted as a charitable deduction. The QCD must be paid by the IRA trustee directly to a qualified charity eligible to receive tax-deductible contributions.

However, there is a statutory limit for QCDs that is adjusted annually for inflation:

• 2024: $105,000
• 2025: $108,000

QCDs may exceed these limits, but any amount above the limit is taxable income. These limits apply to each individual, so a married couple can each donate up to the limit. QCDs are not reported separately in Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc. To report the QCD in the tax return, report the full IRA distribution on the appropriate line, then subtract the QCD portion from the total distribution and enter that amount as the taxable portion. Write "QCD" next to this line.

If the IRA has any nondeductible contributions, then Form 8606, Nondeductible IRAs must be filed to determine the remaining basis in the IRA.

To prevent taxpayers from claiming deductions for IRA contributions while also making QCDs, QCDs excludable from income are reduced by the excess of IRA contributions deducted for the taxable year and any prior year before age 70½ or older minus the total excludable amount of QCDs in those earlier years. In other words, only contributions to the IRA before reaching age 70½ will not lower available QCD exclusions in the future.

The taxpayer must get a written acknowledgement of their contribution from the qualified charity that would be required for a charitable deduction: the contribution date and amount and whether any value was received for the contribution. More: Deductibility Of Charitable Contributions, Substantiation and Reporting Requirements

Because the QCD exclusion does not increase taxable income, other benefits from keeping AGI lower may include:

• lowering or eliminating the tax on Social Security benefits
• lowering the 3.8% net investment income tax on investment income
• increasing the deduction for unreimbursed medical expenses
• preserving eligibility for the $25,000 loss allowance for passive income received from rental properties

So, qualified charitable distributions may reduce your taxable income more than receiving the RMD, then donating it to the charity and claiming a deduction. However, qualified charitable distributions are only allowed for IRA accounts, not other types of retirement accounts, such as 401(k)s, or SEP or SIMPLE IRAs.

A 1-time donation of a portion of the permitted QCD to a charitable remainder trust or a charitable remainder annuity trust is also allowed but only if they are funded only with qualified charitable distributions. The allowable portion is also adjusted for inflation:

• 2024: $53,000
• 2025: $54,000

Inherited Traditional IRAs

Distributions to beneficiaries are generally taxable and are not subject to the 10% tax penalty. As with distributions to IRA account holders, any portion of a distribution allocable to nondeductible contributions is nontaxable.

If a surviving spouse is the sole beneficiary of a deceased spouse's IRA, then the surviving spouse may treat the account as her own IRA or roll it over to her own IRA, which will then be treated under the regular rules.

If the decedent's estate is named as a beneficiary, then distribution requirements depend on when the decedent died. If before the RMD date, then the entire amount must be distributed by the 5^th year after the year of death; otherwise, distributions to non-spouse beneficiaries must at least equal the RMD based on the life expectancy of the beneficiary when the donor died, and the entire amount must be withdrawn by the 10^th year.

Although a non-spouse beneficiary can transfer an IRA account to another financial institution, the account must, nonetheless, be maintained in the name of the deceased IRA owner, but for the benefit of the beneficiary. Although the financial institution will record the beneficiary's Social Security number on the account for tax purposes, the name on the account must remain that of the deceased IRA owner; otherwise, if the name is changed to that of the beneficiary, the IRS will treat it as if the entire amount has been distributed to the beneficiary.

If the original account owner was required to take RMDs, then a beneficiary of that account must receive an RMD for every year after the year of the decedent's death until the sooner of when the account is depleted or 10 years. The entire amount must be withdrawn within 10 years. The RMD is calculated similarly to how it is calculated for account owners. The applicable tax penalty, 25% or 10%, on any amount less than the RMD also applies to beneficiaries. However, if the non-spouse beneficiary only takes the RMD each year, then the amount that must be withdrawn in the 10th year may be sizable, which may incur hefty taxes.

Designated Beneficiary

When there is more than 1 beneficiary, the maximum life expectancy used for which to determine the RMD for all the beneficiaries depends on the life expectancy of the designated beneficiary, which is determined by September 30 of the year after death. Only 1 designated beneficiary for each inherited traditional IRA is permissible.

A designated beneficiary must have been a beneficiary when the owner died and by September 30 after the year of death. The reason for waiting until September 30 of the next year to name a designated beneficiary is because some beneficiaries may want their inheritance as a lump sum or may want to disclaim the inheritance. The designated beneficiary is determined either by the terms of the IRA plan, or if the plan allows, by election; otherwise it will be the oldest beneficiary. If the beneficiary dies during the interim between the account owner's death and September 30, then that beneficiary rather than his successor beneficiary will still be considered a beneficiary for determining the distribution period. If the designated beneficiary was the owner's surviving spouse, but does not live long enough to start receiving distributions, then the IRA account will be treated as being owned by the surviving spouse. Individuals named as beneficiaries by the estate, and estates or charities cannot be a designated beneficiary; trust beneficiaries may qualify under certain conditions.

An exception allows multiple individual beneficiaries to separate their accounts to figure their RMD's based on their individual life expectancies if the accounts are set up by December 31 in the year after the owner's death.

However, if a beneficiary is not an individual, such as a charity or the decedent's estate, then there is no designated beneficiary. In such a case, if the owner died before the required distribution date, then the entire account must be distributed by the 5^th yearend after the year of death; otherwise, the decedent owner's life expectancy as of the year of death must be used to determine the RMD's for each beneficiary, unless the interest of the non-individual beneficiary is distributed and separate IRA accounts are set up for the individual beneficiaries by the September 30 deadline. So if the owner died after April 1 after the year in which he turned 73 and named his estate as the IRA beneficiary, and he had a 10 year life expectancy as of the year of death, then the IRA balance must be divided by 10 to determine the 1^st RMD, then the remaining balance divided by 9 to determine the next year's RMD, etc. However, if the owner died younger, then the entire balance must be distributed by the 5^th year-end after the year of death. The 5-year rule always applies when the owner dies before the required beginning date for RMDs and there is no designated beneficiary.

A trust cannot be treated as a designated beneficiary, but, if the trust is irrevocable, the beneficiaries of the trust can be designated as the beneficiaries, if certified documentation listing the trust beneficiaries is provided to the IRA trustee by October 31 after the year-end of the decedent's death, and that any subsequent changes to the trust instrument will also be reported to the IRA trustee if it changes any certified information. The beneficiaries cannot have separate accounts and the RMD for each is based on the life expectancy of the oldest beneficiary.

A designated beneficiary must receive the 1^st RMD during the year after the owner's death. The RMD is calculated just as it was for the owner, except that the life expectancy is based on the Beneficiary's Single Life Expectancy Table published by the IRS. If the beneficiary dies before withdrawing all benefits, then her successor beneficiary must continue to use the same life expectancy of the decedent beneficiary.

A beneficiary of an IRA can disclaim the inheritance through a qualified disclaimer (IRC §2518), where the refusal is in writing and given to the title holder or its legal representative no later than the later of 9 months after the owner's death or by the September 30 date for determining the designated beneficiary. However, an estate cannot disclaim an IRA that is part of the estate.

A general rule of disclaimers is that the disclaimant cannot have received the property being disclaimed. For IRA beneficiaries, they cannot have received any distributions. However, Revenue Ruling 2005–36 does allow a beneficiary to receive an RMD in the year of the account owner's death while still allowing the beneficiary to disclaim the remaining amount in the IRA. All or part of the balance can be disclaimed except for the income allocable to the RMD. The disclaimed amount must be paid either outright to the successor beneficiary or must be segregated in a separate IRA for his benefit.

Surviving Spouses As Beneficiaries

A surviving spouse who is a sole beneficiary with unlimited withdrawal rights of an IRA may change the name on the account to her own, thus subjecting the IRA account to the same rules as if it were her own account. If the surviving spouse does not receive an RMD within the 1^st year after the death or contributes to the inherited IRA, then the account is deemed to be the surviving spouse's thereafter.

If a surviving spouse receives a distribution from the decedent spouse's IRA, any amounts exceeding the RMD can be rolled over into her own IRA, but the RMD must be reported as income when received.