Understanding IRA investment options includes understanding the distribution rules. If you make the wrong decisions after the investment is made, you can seriously affect the benefits of the investment. The key to understanding the IRS rules on IRA distributions includes understanding the differences between the Roth IRA and the traditional IRA. If you are taking a distribution after the age of 59 & 1/2, then there is no penalty (in addition to taxation) on your distribution.
From a contribution standpoint, the traditional IRA could be deductible at the time of contribution up to a certain point, and under certain conditions. If your contributions were deductible from your taxable income at the time of contribution, then all of your traditional IRA is taxable when it is distributed. A traditional IRA was not necessarily deductible, however, and if it was not deductible, and if the 8606 was filed in a timely manner, then there is a clear record of exactly how much of a “basis” (an amount that has already been taxed) you have in your traditional IRA. That basis will be not be taxable upon distribution. The interest paid on your traditional IRA, however, is always taxable, but remember that there is no law saying that your IRA necessarily made money. Instead of having earnings, your IRA may have lost money, in which case it is even more important to know how much of the money, if any, in the IRA has already been taxed.
A contribution to a Roth IRA is never deductible from income, and if the rules are followed regarding distribution, even the earnings, if any, on a Roth IRA are not taxable.
If qualified funds are “rolled over” into an IRA from a qualified plan or another IRA, then there is no taxation and no penalty on the rollover distribution unless it is being rolled over from a traditional retirement account to a Roth IRA, which has more extensive rules regarding distribution. The traditional to Roth rollover is called a “ re characterization” and the taxes must be paid upon the money, usually in the year of the re characterization, before it can have the Roth designation. Each re characterization has its own five year period before it is fully eligible for qualified Roth distribution.
The formal rollover from a traditional IRA or qualified plan is usually between institutions, and a 1099–R is issued with the code G in box 7, and there is no taxation, penalty, or withholding. If you have taken an early distribution in the form of a check made out to you on an IRA or a qualified plan, however, you still have 60 days to re-invest in another IRA with no taxation or penalty. Be aware that the entire distribution is eligible for re-investment within this time period, but the check amount will probably reflect withholding in the form of 10 to 20% to help cover taxes and possible penalties on the distribution. For example, you took an early distribution of $6,000 to take a family trip to Spain. Your plan dictated that $1,200 (20%), be withheld, so you received a check for $4,800. The family reunion in Spain was cancelled before you bought the airline tickets, and you decided to put the money back into an IRA. If you put back in the $4,800, then you will owe taxes on $1,200. If you are under 59 &1/2, then you will owe another $120 as well. To avoid tax and penalty, take $1,200 out of your savings account, or borrow it from your brother, and roll it over into another IRA within 60 days. The $1,200 withheld will help pay your taxes on your 1040, and hopefully you will get a good refund after the first of the year when you file.
If you are given a distribution because of the failure of your financial institution, there are regulations to accommodate frozen accounts and hardships created by a 60-day window, but you are still responsible for penalties and tax if you do not act in a timely manner.
The most common penalty on an IRA is an early distribution penalty, an extra tax of 10% upon any IRA funds that are distributed before the beneficiary is 59 ½ years old. In the case of a Roth IRA, there is the added stipulation that the Roth IRA be in existence at least 5 years from the beginning of the tax year of the contribution before the distribution is qualified. If the distribution is non-qualified, then part or all of the Roth IRA is not only subject to the penalty, but may be taxable as well. The form 8606 clarifies the taxability of an early Roth or traditional IRA distribution, with ordering rules for what funds are considered distributed. If the funds are taken within two years of starting a SIMPLE IRA, the penalty is 25%.
For a Roth IRA, the distribution is considered qualified if it is made because you are disabled, or if it is qualified under the requirements for a first home (with a $10,000 lifetime limit.)
If you inherit a traditional IRA from your spouse, you can choose to make it your own, or you can usually roll it over without penalty. If you inherit it from someone other than your spouse, then there are limits on how long you have to withdraw the assets. If you inherit a Roth IRA, it is considered a qualified distribution.
There are other exceptions to the 10% early distribution penalty. Possible situations where you wouldn’t have to pay the penalty include you having paid excessive medical deductible, you having paid for your own health insurance under certain circumstances, you being disabled, you are receiving distributions as an annuity, the distribution is a qualified reservist distribution, you took the distribution to help with the cost of being a first-time home-buyer, or perhaps the IRS put a levy on a qualified plan.
Under certain circumstances, the payment of higher education expenses qualifies for a waiver of the penalty. Do not assume that you automatically qualify for relief of penalty; many plans require that you establish your need prior to taking the distribution, and that the entire distribution be used for a hardship purpose. Use form 5329 to figure any extra tax unless it is a simple situation of taking the 10% penalty on income reported on a 1099-R with a distribution code of 1; if all or part of this distribution is not subject to tax or penalty because you rolled over all or part with 60 days to a qualified account, then form 5329 is not required.
There are also distribution penalties if you fail to take a timely distribution for a traditional IRA after April 1st of the year after you reach the age of 70 ½. The distribution must be taken by December 31st of that year, or you will face a penalty of 50% of the required minimum distribution. The amount of required distribution is figured using life expectancies and distribution periods. The traditional IRA account balance at the end of the previous year is used to figure the required minimum distribution for any year. Publication 590 at irs.gov will clarify exactly how to figure the distribution.
In addition to distribution penalties, there are also penalties of 6% if you contribute too much to an IRA, and fail to take out the excess contribution (plus earnings) before the due date of the return. The 6% tax will continue to be levied until the excess amount is removed from the IRA. This also applies to any contribution made to your traditional IRA after the age of 70 ½ is reached.
One last form of distribution is an involuntary distribution that results when you or your beneficiary participate in a prohibited transaction that results in the traditional IRA losing its designation as an Individual Retirement Arrangement.
Prohibited transactions include, according to the IRS Publication 590, “. . . borrowing money from your IRA, selling property to your IRA, receiving unreasonable compensation for managing it, using it as security for a loan, or buying property for personal use with IRA funds.” The penalties for prohibited activity are severe.
If the prohibited transaction was made by a fiduciary of the account without your participation, then that party may be liable for a 15% tax on the amount of the transaction, and a 100% tax if the transaction is not corrected. If you have participated in the prohibited activity, then the account will lose its status as an IRA, and you will be considered to have taken a full distribution of the IRA as of the first of the year that the prohibited transaction was made, with the full tax and penalties for early distribution of the entire amount (if applicable) due on your 1040 return for that year.