The tax impact of IRA distributions - individual retirement accounts - Personal Finance

Healthcare Financial Management, June, 1993 by William G. Kistner

Individuals may not keep funds in their individual retirement accounts (IRA) forever. The funds must eventually be withdrawn or else an excise tax must be paid on excess accumulations. IRA owners have two withdrawal choices--they may withdraw the entire balance in their IRA accounts by the required beginning date or they may withdraw periodic distributions from their IRA accounts by the required beginning date.

The required beginning date is when an IRA owner reaches age 70 1/2. The owner must receive the entire balance in the IRA account or begin receiving periodic distributions from the IRA account by April 1 of the year following the year in which he or she turns 70 1/2. If the distributions are to be made over a period of years, the owner must receive at least the minimum amount required for each year starting with the year he or she turns 70 1/2. If the owner did not receive any distributions (or the full amount of the required minimum distribution) in the year he or she turned 70 1/2, then the owner must receive the required minimum distribution amount by April 1 of the next year. Required distributions for later years must be made by Dec. 31 of each year.

The minimum distribution is based on either the life expectancy of the IRA owner or the joint life expectancy of the owner and spouse, or other designated beneficiary. If the payments are based on the IRA owner's life expectancy or on the joint life expectancy of the owner and spouse, the IRA owner is entitled to redetermine the life expectancies annually. This may enable an IRA owner to cut down on the amount of the minimum annual distribution.

Rollovers

There are rules that limit the withdrawal and use of IRA assets. When an IRA owner receives a distribution from an IRA, he or she must generally include the distribution amount in gross income for that year. However, a qualified rollover is an exception to this general rule.

A rollover is a tax-free distribution of cash or other assets from one retirement plan into another retirement plan. The amount rolled over tax-free is generally taxable later when the new plan pays out that amount to the investor.

There are two types of rollover contributions to an IRA. In the first type, an investor puts the amount he or she receives from one IRA into another. In the second type, the investor puts the amount from a qualified employer retirement plan (pension, profit sharing, tax-sheltered annuity) into an IRA. To qualify for tax-free treatment, the investor must make the rollover contribution by the 60th day after the day he or she receives the distribution from the old IRA or his or her employer's plan.

If an investor withdraws assets from an IRA, he or she may roll over part of the withdrawal tax free into another IRA and keep the rest. The amount the investor keeps is generally taxable (except to the extent it is a return of nondeductible contributions) and may be subject to a 10 percent additional tax on premature distributions and a 15 percent tax on excess distributions.

An investor may take (receive) a distribution from a particular IRA and make a rollover contribution to another IRA only once in any one-year period. The one-year period begins on the date he or she receives the IRA distribution, not on the date he or she rolls it over into another IRA. This rule applies separately to each IRA owned.

A transfer of funds in an IRA from one trustee directly to another, either at the investor's request or at the trustee's request, is not a rollover. It is, however, a tax-free transfer. As such, it is not affected by the one-year waiting period that is required between rollovers.

New income tax withholding rules apply to distributions made from qualified employer plans after 1992. Withholding at a rate of 20 percent is required on a distribution unless it is transferred directly from an employer to an IRA trustee or another employer plan.

The new withholding rules do not apply to distributions from IRAs (or Simplified Employee Pensions/SEPs). However, if an investor wants to rollover a qualified plan distribution to an IRA, he or she must transfer the amount directly from his or her employer to an IRA trustee or another employer plan. Otherwise, 20 percent of the distribution will be withheld while 100 percent of the distribution must be rolled over within 60 days. If the investor does not have the money to cover the 20 percent shortage, income taxes (and possibly a 10 percent penalty) will be due on the amount not rolled over.

Nonrollover distributions

IRA distributions are taxed in a manner similar to annuities. If nondeductible contributions are not made, all distributions from an IRA account are taxed as ordinary income. Investors may not use special five- or 10-year averaging on a lump-sum distribution from their IRAs, even if the account is a rollover from a qualified plan. If nondeductible contributions were made, a portion of the distribution may be excludable from income. The excludable amount is computed as follows: