The laws applicable to withdrawals (distributions) from individual retirement accounts (IRA’s) and qualified retirement plans are numerous and complex. It is important to clearly understand your choices and obligations when it comes to receiving the proceeds from your retirement savings account. This article addresses the general issues facing IRA account holders when receiving distributions.
The taxation of IRA distributions can be separated into two components: ordinary income tax treatment and potential additional tax penalties.
Ordinary Income Tax Treatment
Ordinary income tax treatment of your IRA distribution depends upon whether your contributions were “deductible” or “non-deductible” (or, “pre-tax” or “after-tax”) when they were made. If your contributions qualified as deductible in the year that you made them, you were able to reduce your taxable income by the amount of the contribution in that year. When you withdraw these deductible contributions, you will be subject to the taxes on these contributions. If your contributions did not qualify as deductible, they were categorized as non-deductible and you were not able to defer the taxes on the amount you contributed.
The tax treatment of IRA distributions from the two types of contributions is summarized below:
IRS Form 8606 is used to calculate the nontaxable and taxable portions of your withdrawal.
If you withdraw funds from your IRA prior to age 59 1⁄2, you may be subject to a 10% early withdrawal penalty with certain exceptions. These exceptions include:
You can also avoid the 10% early withdrawal penalty and any other taxes due on your withdrawal if you rollover the funds to the same or another IRA within 60 days of receiving the funds. You are only allowed one rollover per person within a 12-month period.
Between the ages of 591⁄2 and 72, you may generally withdraw assets from your IRA without penalty. Distributions can take the form of lump sums, one time requests or regularly scheduled payments.
When you reach age 72, the IRS requires that you begin taking at least a minimum distribution each year. This minimum distribution is called the Required Minimum Distribution (RMD). A 50% excise tax may be imposed if the amount actually distributed is less than the RMD.
The following two factors are used in determining your IRA’s RMD:
The formula applied each year is:
RMD = Fair Market Value of all IRA’s as of December 31
Uniform (or joint) life expectancy factor from IRS tables
Unlike many qualified retirement plans such as 401(k)s, owners of multiple IRAs can choose to fulfill their RMD from any one or combination of their IRAs. The distributions do not have to be taken from each IRA pro-rata.
Distributions Upon Death
In 2020, the SECURE (Setting Every Community Up for Retirement Enhancement) Act was enacted, changing how retirement plans are distributed upon death (amongst other changes). The SECURE Act creates three types of IRA beneficiaries: Eligible Designated Beneficiaries (EDBs), Designated Beneficiaries, and Non-Designated Beneficiaries.
When the original owner of an IRA dies, the beneficiary must be determined by September 30th of the following year. New rules have been created under the SECURE Act as to how funds from an IRA are to be distributed depending on the classification of the beneficiary. If the beneficiary meets the requirements to be considered an EDB, generally, the funds from the decedent’s IRA can be distributed over the beneficiary’s life expectancy. If the beneficiary is a non-spouse individual (and does not meet other EDB requirements) or a certain trust, then the funds must be distributed from the decedent’s IRA over a 10-year period following the date-of-death.
In the event the beneficiary of the IRA is an estate, charity, or a non-designated beneficiary trust, then distributing funds from the decedent’s IRA depend on whether the decedent had begun their Required Minimum Distribution (RMD). If the decedent died prior to beginning their RMD, then the non-designated beneficiary must distribute the funds from the IRA over a 5-year period following the date-of-death. If the decedent died after they begun their RMD, then the non-designated beneficiary can take distributions based on the life expectancy of the deceased owner computed as of the year of his or her death.
Other Distribution Considerations
All assets held in IRA accounts upon the owner’s death are included in the owner’s taxable estate. As a result, the IRA assets may be subject to estate taxes upon the owner’s death, as well as income taxes when the beneficiary distributes assets from the IRA.
We at Bingham, Osborn & Scarborough, LLC (B|O|S), are ready to work with clients, their attorneys and tax professionals on the merits and specifics of these and other investment and financial planning options. For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by B|O|S, please visit our website at www.bosinvest.com.
Updated January 2021
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