3649 / When are funds in an IRA taxed?

A distribution of a nontransferable, nonforfeitable annuity contract that provides for payments to begin by age 73 (72 for 2020-2022, 70½ prior to 2020) 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.

Contributions to an IRA may be returned to the participant in a tax-free manner if certain conditions are met as discussed in Q 3670 (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.¹ 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.

Where a taxpayer transferred funds from a single IRA into two newly-created IRAs, the direct trustee-to-trustee transfers were not considered distributions under IRC Section 408(d)(1).² The division of a decedent’s IRA into separate subaccounts does not result in current taxation of the IRA beneficiaries.³

A distribution of any amount may be received free of federal income tax to the extent the amount is then contributed within 60 days to another plan under qualified rollover rules ( Q 4004).

For the penalty tax imposed on accumulated amounts not distributed in accordance with the required minimum distribution rules, see Q 3682.

If any assets of an individual retirement account are used to purchase collectibles (works of art, gems, antiques, metals, etc.), the amount so used will be treated as distributed from the account (and also may be subject to penalty as an early distribution). A plan may invest in certain gold or silver coins issued by the United States, any coins issued under the laws of a state, and certain platinum coins. A plan may buy gold, silver, platinum, and palladium bullion of a fineness sufficient for the commodities market if the bullion remains in the physical possession of the IRA trustee.⁴ A plan may purchase shares in a grantor trust holding such bullion.⁵

If any part of an individual retirement account is used by the individual as security for a loan, that portion is deemed distributed on the first day of the tax year in which the loan was made.⁶ Amounts rolled over into an IRA from a qualified plan by one of the 25 highest paid employees, however, may be pledged as security for repayments that may have to be made to the plan in the event of an early plan termination.⁷ A less-than-60-day interest-free loan from IRA accumulations is possible under the rollover rules ( Q 4012).⁸

If the owner of an individual retirement annuity borrows money under or by use of the contract in any tax year, including a policy loan, the annuity ceases to qualify as an individual retirement annuity as of the first day of the tax year and the fair market value of the contract would be deemed distributed on that day.⁹

If an individual engages in a prohibited transaction ( Q 3976) with his or her IRA, such IRA ceases to qualify as such as of the first day of that tax year when the prohibited transaction occurred; the individual, however, is not liable for a prohibited transaction tax.¹⁰ The fair market value of all the assets in the account is deemed distributed on that day.¹¹ If the account is maintained by an employer, only the separate account of the individual involved is disqualified and deemed distributed.¹²

The transfer to an individual retirement account of a personal note received in a terminating distribution from a qualified plan and the holding of that note is a prohibited transaction.¹³

The use of IRA funds to invest in a personal retirement residence of the taxpayer is considered a prohibited transaction under IRC Section 4975(c)(1)(D) and, thus, is treated as a distribution.¹⁴

Whether a purchase of life insurance in conjunction with an individual retirement plan but with non-plan funds constitutes a prohibited transaction apparently depends on the circumstances. The IRS has held that the purchase of insurance on the depositor’s life by the trustee of the account with non-plan funds amounted to an indirect prohibited transaction by the depositor.¹⁵ The IRS also has ruled that the solicitation by an association of individuals who maintain individual retirement plans with the association for enrollment in a group life plan did not result in a prohibited transaction where premiums would be paid by the individuals and not out of plan funds.¹⁶

Institutions may offer limited financial incentives to IRA and Keogh holders without running afoul of the prohibited transaction rules provided certain conditions are met. Generally speaking, the value of the incentive must not exceed $10 for deposits of less than $5,000 and $20 for deposits of $5,000 or more. These requirements also are applicable to SEPs that allow participants to transfer their SEP balances to IRAs sponsored by other financial institutions and to SIMPLE IRAs.¹⁷