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 different 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 70½;
- 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 is passed 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, there are some transactions that are also considered distributions. A conversion of a traditional IRA to a Roth IRA is considered a distribution, so the taxpayer must include the distribution as income in the year of the distribution. 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 that 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 was used to discharge 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 generally 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 generally not taxable.
To keep track of nondeductible contributions, the taxpayer should retain all copies of Forms 8606 for which non-deductible contributions have been recorded, Forms 5498 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 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 include the following:
- Tax-Free Percentage = Total Nondeductible Contributions / Total Amount in All IRA Accounts
- Tax-Free Portion of Distribution = Distribution Amount × Tax-Free Percentage
- Taxable Portion of Distribution = Distribution – Tax-Free Portion of Distribution
If the taxpayer is a beneficiary of one 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.
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 taxpayer used the money to pay medical expenses that exceeded the medical-expense AGI floor (10% of adjusted gross income, 7.5% if at least 65)
- 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 amount of the distribution that exceeds 10% of the taxpayer's AGI after including the taxable IRA distribution is tax-free. Further, the expenses must be paid in the same year as the distribution.
- the taxpayer used it to pay 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.
- the taxpayer paid 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.
- the distribution not exceeding $10,000 was used to buy a 1st 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 taxpayer was a 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.
- 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 probably be provided, 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 does not have to 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 (RMD)
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 70½. The 1st distribution must be received by April 1 of the year following the year when the taxpayer reaches 70½. However, it is generally more prudent for the taxpayer to take this distribution when she reaches age 70½ since waiting until the following year will result in 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 50% tax penalty will be assessed on the difference unless there was a reasonable cause for the shortfall. So if you are required to take a $3000 distribution for the year, but instead, only took $2000, then a $500 (= $1000 × 50%) penalty will applied to the shortfall. Both the calculation of the penalty or a request of a waiver of the penalty must be made on Form 5329, which is attached to the taxpayer's tax return.
The RMD is based on the Uniform Lifetime Table published by the IRS, which lists the life expectancy for taxpayers by age. The trustee or custodian of the traditional IRA must report to the taxpayer the amount of the RMD by January 31 of the year of the required distribution.
In certain cases, the taxpayer will have to calculate the RMD. To figure the RMD, the RMD for each traditional IRA must be calculated separately, then totaled. Once the total has been determined, then the taxpayer can receive the RMD from just one of the accounts.
The IRA account balance at the end of the previous year in which the taxpayer reaches 70½ must be used, even if the taxpayer chooses to receive the distribution in the following year. In calculating the balances, any rollovers within 60 days of the year-end must be taken into account, even if the contribution was made in the next year.
The next step is to divide the account balance by the applicable life expectancy. The Uniform Lifetime Table, which can be found in Appendix C of Publication 590, provides 3 tables:
- Table I is for beneficiaries.
- Table II is for married owners whose spouse is at least 10 years younger.
- Table III is for unmarried owners, married owners with a spouse who is no more than 10 years younger, or for married owners whose spouses are not the sole beneficiaries of the IRA.
Table III is a joint life expectancy for the taxpayer and a deemed beneficiary who is exactly 10 years younger, regardless of the beneficiary's actual age or even if the IRA owner has not named a beneficiary or if the taxpayer changes the beneficiary. When looking up the life expectancy from the table, the taxpayer should use the age that she will be on her birthday in that year. The RMD must be recalculated every year based on the life expectancy for the increased age.
The Uniform Lifetime Table is based on the assumption that the beneficiary of the IRA is 10 years younger than the taxpayer. A taxpayer with a spouse who is more than 10 years younger should use the Joint Life and Last Survivor Expectancy Table, which will yield a lower RMD, since the payouts will usually occur over a longer time. However, the spouse must be the sole beneficiary of the entire interest in the IRA during the entire calendar year for which the RMD is being figured; otherwise, the Uniform Lifetime Table must be used. If the taxpayer was married at the beginning of the year, but subsequently divorces or the spouse dies, then the taxpayer can still use the joint table when calculating RMD for that year. When looking at the values in the table, the spouses' age is the age attained on their birthdays in that year.
Distributions from Individual Retirement Annuities
Distributions in the form of an annuity can be 1 of 3 methods that have been approved by the IRS: required minimum distribution method, fixed amortization method, 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 will be applied retroactively to all taxable payments received before age 59½ plus interest, unless the taxpayer becomes totally disabled or the payments are to beneficiaries of a deceased IRA owner.
In most cases, the scheduled arrangement of payments cannot be changed unless the taxpayer becomes disabled. However, in some cases, such as a division of an IRA because of divorce, 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 is equal to $1,000,000 and the taxpayer has a 25 year life expectancy, then the minimum 1st distribution is calculated by dividing 1,000,000 by 25, or $40,000. The 2nd year distribution is equal to the account balance on the previous year-end divided by 24, and so on. Payments based on the joint life and last survivor expectancy will always be smaller, since a joint life expectancy is always longer than for one person.
The fixed amortization method amortizes the IRA account balance, in which the payments eventually reduce the account balance to 0. The amount of the payments depends on the interest rate used to calculate the amortization.
Under the fixed annuitization method, an annuity factor, which is calculated from a mortality table published in Revenue Ruling 2002-62, is used to determine the amount of the payment. The 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 be greater than 120% of the federal midterm rate for either of the 2 months preceding the 1st distribution. A tax professional will be needed to calculate the RMD using the non-RMD methods.
Qualified Charitable Distributions
Taxpayers who will be at least 70½ by the end of the calendar year may donate up to $100,000 in cash directly from their IRAs to qualified charities. These qualified charitable distributions (QCDs) are tax-free to the taxpayer and are counted for RMDs. Moreover, the $100,000 limit is separate for each spouse, so a married couple can contribute up to $200,000 from their IRA if they both satisfy the age requirements.
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 that is 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 date of required distributions, then the entire amount must be distributed by the 5th year after the year of death; otherwise, the distributions must be at least equal to the RMD based on the life expectancy of the beneficiary in the year of death.
Although a nonspouse 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, then the IRS will treat it as if the entire amount has been distributed to the beneficiary.
A beneficiary must receive an RMD for every year after the year of the decedent's death until the account is depleted. The RMD is calculated similarly to how it is calculated for account owners. The 50% tax penalty on any amount less than the RMD also applies to beneficiaries.
|Beneficiary's Life Expectancy for 2013||30|
|IRA Account Balance at End of 2012||$100,000|
|RMD for 2013||$3,333||= Account Balance at Previous Year End/Life Expectancy This Year|
|Account Balance at End of 2013||$103,000||Includes investment earnings for the year.|
|Life Expectancy in 2013||29||Obviously, 1 less than the previous year.|
|RMD for 2014||$3,552||= Account Balance at Previous Year-End/Life Expectancy This Year|
Tax tip: Name a contingent beneficiary who is young so that the minimum required distributions will be smaller. If the account earns more than the withdrawal rate, those earnings can be tax-deferred. Otherwise, if no contingent beneficiary is named, then the money will go to the estate, in which case the beneficiaries must pay the income taxes on the account by December 31 of the 5th year following the death of the donor, if the donor died before the start of the RMD period.
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-end of death. The reason for waiting until September 30 of the following year to name a designated beneficiary is because some beneficiaries may decide to receive their inheritance as a lump sum or the beneficiary may 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, and 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 one of the beneficiaries 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 5th year-end 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 70½ 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 1st RMD, then the remaining balance divided by 9 to determine the next year's RMD, and so on. However, if the owner died younger, then the entire balance would have to be distributed by the 5th 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 1st 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 1st 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, then any amounts exceeding the RMD can be rolled over into her own IRA, but the RMD must be reported as income in the year in which it is received.