As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
How are amounts distributed from a traditional IRA taxed?
Distributions from a traditional IRA generally are taxed under IRC Section 72 (relating to the taxation of annuities). Under these rules, a portion of the distribution may be excludable from income. The amount excludable from the taxpayer’s income for a year is that portion of the distribution that bears the same ratio to the amount received as the taxpayer’s investment in the contract (i.e., nondeductible contributions) bears to the expected return under the contract. In no case will the total amount excluded exceed the unrecovered investment in the contract.
All traditional IRAs are treated as one contract, all distributions during the year are treated as one distribution, and the value of the contract, income on the contract, and investment in the contract are computed as of the close of the calendar year with or within which the taxable year begins. Thus, the nontaxable portion of a distribution (whether from a traditional individual retirement annuity or account) is equal to the following:
x Distribution Amount
Total IRA Account Balance +
Distribution amount +
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The total IRA account balance is the balance in all traditional IRAs owned by the taxpayer, as of December 31 of the year of the distribution. To this amount is added the amount of any distributions made (i.e., the amounts for which the nontaxable portion is being computed) and any outstanding rollover amounts (i.e., any amount distributed by a traditional IRA within sixty days of the end of the year, which has not yet been rolled over into another plan, but which is rolled over in the following year). If it is not rolled over, the amount is not treated as an outstanding rollover.
Nondeductible contributions will not be excluded from gross income as investment in the contract where the taxpayer is unable to document the nontaxable basis through the filing of Form 8606, Nondeductible IRAs (Contributions, Distributions and Basis) for the year in which such nondeductible contributions were made and the year in which they were distributed.
An individual may recognize a loss on a traditional IRA, but only when all amounts have been distributed from all traditional IRAs and the total distributed is less than the individual’s unrecovered basis. The deduction for the loss is a miscellaneous itemized deduction.
Despite the pro-rata rule applicable generally to distributions from a traditional IRA, distributions after 2001 that are rolled over to a qualified plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan are treated as coming first from all non-after-tax contributions and earnings in all of the IRAs of the owner. Because after-tax contributions cannot be rolled over to eligible retirement plans other than another IRA, this ordering rule effectively allows the owner to rollover the maximum amount permitted. Appropriate adjustments must be made in applying IRC Section 72 to other IRA distributions in the same taxable year and subsequent years.
How are amounts distributed from a Roth IRA taxed?
Where a Roth IRA contains both contributions and conversion amounts, there are ordering rules that apply in determining which amounts are withdrawn. In applying the ordering rules, traditional IRAs are not aggregated with Roth IRAs. All Roth IRAs are aggregated with each other. Regular Roth IRA contributions are deemed to be withdrawn first, then converted amounts second (in order if there has been more than one conversion). Withdrawals of converted amounts are treated first as coming from converted amounts that were includable in income. The ordering rules continue to treat earnings as being withdrawn after contributions.