As part of AdvisorOne’s Special Report, 20 Days of Tax Planning Advice for 2013, throughout the month of March, we are partnering with our Summit Business Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In this fifth article, we look at converting a retirement plan to a Roth IRA.
Q. When are funds in an IRA taxed?
Funds accumulated in a traditional IRA generally are not taxable until they actually are distributed. Funds accumulated in a Roth IRA may or may not be taxable on actual distribution. Special rules may treat funds accumulated in an IRA as a “deemed distribution” and, thus, includable in income.
A distribution of a nontransferable, nonforfeitable annuity contract that provides for payments to begin by age 70½ and not to extend beyond certain limits is not taxable, but payments made under such an annuity would be includable in income under the appropriate rules.
A contribution (excess or otherwise) may be distributed income tax free in certain circumstances(provided, in the case of a traditional IRA, that no deduction was allowed for the contribution). If net income allocable to the contribution is distributed before the due date for filing the tax return for the year in which the contribution was made, it must be included in income for the tax year for which the contribution was made even if the distribution actually was made after the end of that year. With respect to distributions of excess contributions after this deadline, the net income amount is included in income in the year distributed. Any net income amount also may be subject to penalty tax as an early distribution.
An individual may transfer, without tax, the individual’s IRA to his or her spouse or former spouse under a divorce or separate maintenance decree or a written instrument incident to the divorce. The IRA then is maintained for the benefit of the former spouse. Any other assignment of an IRA is a deemed distribution of the amount assigned.
Where an individual rolled over his interest in a tax sheltered annuity to an IRA, pursuant to a QDRO, the subsequent transfer of the IRA to the individual’s spouse was considered a “transfer incident to a divorce” and, thus, nontaxable to either spouse.
A taxpayer was liable for taxes on a distribution from his IRA that he subsequently turned over to his ex-wife in satisfaction of a family court order because it was not a “transfer incident to divorce” and the family court order was not a QDRO because it did not specifically require the transfer of assets to come from the IRA. A transfer of funds between the IRAs of a husband and wife that does not come within the divorce exception is a deemed distribution despite IRC provisions that provide that no gain is recognized on transfers between spouses.
The transfer of a portion of a husband’s IRA to his wife to be placed in an IRA for her benefit that was the result of a private written agreement between the two that was not considered incident to a divorce was not eligible for nontaxable treatment under IRC Section 408(d)(6).
Where a taxpayer received a full distribution from his IRA and endorsed the distribution check over to his soon-to-be-ex-wife, the husband was determined to have failed to satisfy the requirements for a non-taxable transfer incident to divorce and was liable for taxation on the entire proceeds of the IRA distribution. Where two traditional IRAs were classified as community property, the distributions of the deceased spouse’s community interest in the IRAs to relatives other than her surviving husband were taxable only to those recipients and not to the husband.
State community property laws, although disregarded for some purposes, are not preempted by IRC Section 408(g). In a case of first impression, the Tax Court ruled that the recognition of community property interests in IRAs would conflict with existing federal tax rules. IRC Section 408(g) requires application without regard to community property laws. By reason of IRC Section 408(g), the former spouse is not treated as a distributee on any portion of the IRA distribution for purposes of federal income tax rules despite the former spouse’s community property interest in the assets. Therefore, a distribution from an IRA to a former spouse is taxable to the account holder unless it is executed pursuant to decree of divorce, or other written maintenance decree under IRC Section 408(d)(6).
Where taxpayers requested that an IRA be reclassified under state marital property law from individual property to marital property, no distribution under IRC Section 408(d)(1) was deemed to have occurred.
The involuntary garnishment of a husband’s IRA and resulting transfer of such funds to the former spouse to satisfy arrearages in child support payments was a deemed distribution to the husband because it discharged a legal obligation owed by the husband.