IRA Distribution Tax Rules

By Clifton Linton
Senior Writer, mPower

In This Story Taxes and Paperwork Deductible Contributions Nondeductible Contributions Qualified Roth Distributions Nonqualified Roth Distributions

In 1987, I opened my first IRA. I put $2,000 in the account and deducted that from my taxable income.

A few years later, I was contributing to a 401(k) plan at work and earned enough that I didn't qualify to deduct my IRA contribution. But, occasionally at the end of the month, I had some extra cash and decided to put it in my IRA on an after-tax basis. I figured that was the right thing to do.

minute: read this article at a glance.

Technical Terms Distribution Early withdrawal penalty Individual retirement account (IRA)

Now, 14 years later, I'm wondering how I will calculate taxes when I start withdrawing money from my IRA at retirement since some contributions were deductible and some weren't. And, what about the money I converted to a Roth IRA?

I looked for an easy-to-understand answer but didn't find one. Much of this information is scattered throughout IRS Publication 590.

So, here are the results of my research — a summary of the most common tax rules as they apply to IRA withdrawals, or distributions, as they are called by the IRS.

Important: Unless noted otherwise, this article assumes you are making withdrawals after reaching age 59½, the age that many of the IRS penalties expire.

Taxes and Paperwork

All taxable IRA distributions are taxed at your ordinary income rate. Because your money is held within a tax-deferred account, there are no capital gains taxes. If you withdraw money before age 59½, it may be subject to a 10 percent early withdrawal penalty.

The "I" in IRA stands for "individual," and this means you have the responsibility to keep up with the paperwork and figure the taxes you owe when you make a withdrawal.

The most important are the 1040, 8606, 1099 and 5498 Forms. Blank copies of these Forms and instructions for using them can be found on the IRS Web site.

• The 1040 is your tax return. That's where you report any IRA distributions (Line 15) and deductible contributions (Line 23).
• On Form 8606, you report nondeductible IRA contributions, traditional to Roth IRA conversions, and Roth IRA distributions.
• Your IRA custodian sends Form 1099 to you and the IRS when you take a distribution from a Roth or traditional IRA. But, this Form will not indicate whether the distribution is taxable. You will have to figure that out using Form 8606 and a worksheet in Publication 590 (page 27).
• Your IRA custodian sends Form 5498 to you and the IRS to report contributions to your traditional or Roth IRA. This form won't say whether a traditional IRA contribution is deductible nor will it specify how much tax is owed if you made a Roth conversion.

Deductible IRA Contributions

If all your IRA contributions were deductible, calculating the taxes isn't difficult. When you take distributions, you will owe income tax on both the earnings and the original contributions.

Nondeductible IRA Contributions

If you made nondeductible contributions to your IRA, figuring out what part of your distribution is taxable is more complicated.

"The custodian doesn't know if the (contribution) was deductible or nondeductible. It's up to the taxpayer to keep track of the nondeductible contributions." — Kent Noard, principal and certified financial planner with Sterling Wood Financial, LLC, in San Mateo, Calif.

Here's an example: Suppose you opened an IRA years ago with a $2,000 nondeductible contribution. Now, the account is worth $12,000, and you want to start taking distributions.

Your $2,000 nondeductible contribution won't be taxable at withdrawal but your $10,000 in earnings will. IRA custodians aren't required to keep records saying whether your original contribution was taxable. That means you need the paperwork from your $2,000 contribution to prove it was made after-tax.

You also have to calculate how much of your distribution will be taxable. If you take all the money out at once, this is fairly simple. However, if you decide to stretch out your distributions over several years, you have to prorate the nondeductible contributions for each withdrawal.

Publication 590 has a worksheet (on page 27) that you can use to figure out how much of the distribution is taxable. You enter the results from that worksheet on Form 8606, which you should file each year with your tax return. You should also keep a copy for as long as you have your IRA because this is your proof that you made deductible contributions.

"The custodian doesn't know if the (contribution) was deductible or nondeductible. It's up to the taxpayer to keep track of the nondeductible contributions," said Kent Noard, principal and certified financial planner with Sterling Wood Financial, LLC, based in San Mateo, Calif.

But, what if you didn't file these forms or keep a paper trail? I confess, I didn't. We couldn't locate statistics, but this situation may be fairly common, Noard speculates. "There are a number of people who have done this. They are thinking the custodian is keeping track," he said.

If you haven't been filing this form, you can file amended returns for the past three years and include it. You can also file forms for earlier years but the IRS will charge you a $50 penalty for each one. If you don't file them, you won't be able to declare nontaxable contributions when you make withdrawals.

To find information for deposits in previous years, see if you still have canceled checks from your deposits or try contacting your IRA custodian to see if it has records of your deposits.

If you filed the correct forms (Form 8606) but neglected to keep copies, you could try contacting the IRS, which keeps copies of old tax returns for 10 years.

If you can't find proof of your nondeductible (after-tax) contributions, you may simply have to pay tax on the withdrawals.

At that point, you have to decide if it's worth fighting the tax bill. Remember, the strength of an IRA is that your contributions grow tax-deferred. If you invested in this account at an early age, most of the account balance will be earnings, which are always taxable. In my case, I only contributed about $150 to my account after-tax and I don't expect the tax bill on that money to be a problem in retirement.

Qualified Roth IRA Distributions

You can take two types of distributions from your Roth IRA — qualified or unqualified.

According to IRS regulations, a qualified, or tax-free, distribution can only be made after the account has been open for a minimum of five years AND one of four additional conditions is met:

• The distribution was made on or after the date you reached age 59½;
• You took the money because you were disabled;
• The money was distributed to a beneficiary or your estate after you died; or
• You took the money to use for a first-time home purchase using rules described by the IRS.

If you opened your Roth IRA in 1998, the first year they were available, you can take your first qualified withdrawal in 2003, provided you meet the other conditions.

Related Reading IRA FAQ: Roth Distributions — Nonqualified Withdrawal Rules Using Periodic Payments to Retire Early New Rules Simplify IRA Required Distributions Roth vs. Traditional Deductible IRA

Nonqualified Roth IRA Distributions

If you want to take your money out of a Roth IRA but don't meet the conditions for a qualified withdrawal, your distribution will be nonqualified. You may owe taxes and/or an early withdrawal penalty on all or part of your earnings but not your contributions.

You are responsible for maintaining the paperwork on your Roth IRA.

Unlike traditional IRAs, Roth IRAs have rules about the order in which money is distributed from the account. This can be advantageous because the first money to come out is your contributions, which are not taxable or subject to an early withdrawal penalty. Here are the rules:

IRS Links IRS Publication 590 For forms and other publications, see the IRS Web site.

• Your nondeductible contributions are always distributed first and you won't have to pay any taxes or penalties on these.
• The next to be distributed is any money converted to a Roth IRA from a traditional IRA — you will owe a 10 percent early withdrawal penalty on this.
• Next is money converted from a traditional IRA that was not taxable at the time of conversion. You won't pay taxes or penalties on this either.
• And, finally are earnings. You will owe taxes and the 10 percent early withdrawal penalty on this money unless you meet one of the exceptions under Internal Revenue Code Section 72(t).

You use IRS Form 8606 to report the distributions and calculate taxes. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

IRA Distribution Tax Rules

By Clifton Linton
Senior Writer, mPower

In This Story Taxes and Paperwork Deductible Contributions Nondeductible Contributions Qualified Roth Distributions Nonqualified Roth Distributions

In 1987, I opened my first IRA. I put $2,000 in the account and deducted that from my taxable income.

A few years later, I was contributing to a 401(k) plan at work and earned enough that I didn't qualify to deduct my IRA contribution. But, occasionally at the end of the month, I had some extra cash and decided to put it in my IRA on an after-tax basis. I figured that was the right thing to do.

minute: read this article at a glance.

Technical Terms Distribution Early withdrawal penalty Individual retirement account (IRA)

Now, 14 years later, I'm wondering how I will calculate taxes when I start withdrawing money from my IRA at retirement since some contributions were deductible and some weren't. And, what about the money I converted to a Roth IRA?

I looked for an easy-to-understand answer but didn't find one. Much of this information is scattered throughout IRS Publication 590.

So, here are the results of my research — a summary of the most common tax rules as they apply to IRA withdrawals, or distributions, as they are called by the IRS.

Important: Unless noted otherwise, this article assumes you are making withdrawals after reaching age 59½, the age that many of the IRS penalties expire.

Taxes and Paperwork

All taxable IRA distributions are taxed at your ordinary income rate. Because your money is held within a tax-deferred account, there are no capital gains taxes. If you withdraw money before age 59½, it may be subject to a 10 percent early withdrawal penalty.

The "I" in IRA stands for "individual," and this means you have the responsibility to keep up with the paperwork and figure the taxes you owe when you make a withdrawal.

The most important are the 1040, 8606, 1099 and 5498 Forms. Blank copies of these Forms and instructions for using them can be found on the IRS Web site.

• The 1040 is your tax return. That's where you report any IRA distributions (Line 15) and deductible contributions (Line 23).
• On Form 8606, you report nondeductible IRA contributions, traditional to Roth IRA conversions, and Roth IRA distributions.
• Your IRA custodian sends Form 1099 to you and the IRS when you take a distribution from a Roth or traditional IRA. But, this Form will not indicate whether the distribution is taxable. You will have to figure that out using Form 8606 and a worksheet in Publication 590 (page 27).
• Your IRA custodian sends Form 5498 to you and the IRS to report contributions to your traditional or Roth IRA. This form won't say whether a traditional IRA contribution is deductible nor will it specify how much tax is owed if you made a Roth conversion.

Deductible IRA Contributions

If all your IRA contributions were deductible, calculating the taxes isn't difficult. When you take distributions, you will owe income tax on both the earnings and the original contributions.

Nondeductible IRA Contributions

If you made nondeductible contributions to your IRA, figuring out what part of your distribution is taxable is more complicated.

"The custodian doesn't know if the (contribution) was deductible or nondeductible. It's up to the taxpayer to keep track of the nondeductible contributions." — Kent Noard, principal and certified financial planner with Sterling Wood Financial, LLC, in San Mateo, Calif.

Here's an example: Suppose you opened an IRA years ago with a $2,000 nondeductible contribution. Now, the account is worth $12,000, and you want to start taking distributions.

Your $2,000 nondeductible contribution won't be taxable at withdrawal but your $10,000 in earnings will. IRA custodians aren't required to keep records saying whether your original contribution was taxable. That means you need the paperwork from your $2,000 contribution to prove it was made after-tax.

You also have to calculate how much of your distribution will be taxable. If you take all the money out at once, this is fairly simple. However, if you decide to stretch out your distributions over several years, you have to prorate the nondeductible contributions for each withdrawal.

Publication 590 has a worksheet (on page 27) that you can use to figure out how much of the distribution is taxable. You enter the results from that worksheet on Form 8606, which you should file each year with your tax return. You should also keep a copy for as long as you have your IRA because this is your proof that you made deductible contributions.

"The custodian doesn't know if the (contribution) was deductible or nondeductible. It's up to the taxpayer to keep track of the nondeductible contributions," said Kent Noard, principal and certified financial planner with Sterling Wood Financial, LLC, based in San Mateo, Calif.

But, what if you didn't file these forms or keep a paper trail? I confess, I didn't. We couldn't locate statistics, but this situation may be fairly common, Noard speculates. "There are a number of people who have done this. They are thinking the custodian is keeping track," he said.

If you haven't been filing this form, you can file amended returns for the past three years and include it. You can also file forms for earlier years but the IRS will charge you a $50 penalty for each one. If you don't file them, you won't be able to declare nontaxable contributions when you make withdrawals.

To find information for deposits in previous years, see if you still have canceled checks from your deposits or try contacting your IRA custodian to see if it has records of your deposits.

If you filed the correct forms (Form 8606) but neglected to keep copies, you could try contacting the IRS, which keeps copies of old tax returns for 10 years.

If you can't find proof of your nondeductible (after-tax) contributions, you may simply have to pay tax on the withdrawals.

At that point, you have to decide if it's worth fighting the tax bill. Remember, the strength of an IRA is that your contributions grow tax-deferred. If you invested in this account at an early age, most of the account balance will be earnings, which are always taxable. In my case, I only contributed about $150 to my account after-tax and I don't expect the tax bill on that money to be a problem in retirement.

Qualified Roth IRA Distributions

You can take two types of distributions from your Roth IRA — qualified or unqualified.

According to IRS regulations, a qualified, or tax-free, distribution can only be made after the account has been open for a minimum of five years AND one of four additional conditions is met:

• The distribution was made on or after the date you reached age 59½;
• You took the money because you were disabled;
• The money was distributed to a beneficiary or your estate after you died; or
• You took the money to use for a first-time home purchase using rules described by the IRS.

If you opened your Roth IRA in 1998, the first year they were available, you can take your first qualified withdrawal in 2003, provided you meet the other conditions.

Related Reading IRA FAQ: Roth Distributions — Nonqualified Withdrawal Rules Using Periodic Payments to Retire Early New Rules Simplify IRA Required Distributions Roth vs. Traditional Deductible IRA

Nonqualified Roth IRA Distributions

If you want to take your money out of a Roth IRA but don't meet the conditions for a qualified withdrawal, your distribution will be nonqualified. You may owe taxes and/or an early withdrawal penalty on all or part of your earnings but not your contributions.

You are responsible for maintaining the paperwork on your Roth IRA.

Unlike traditional IRAs, Roth IRAs have rules about the order in which money is distributed from the account. This can be advantageous because the first money to come out is your contributions, which are not taxable or subject to an early withdrawal penalty. Here are the rules:

IRS Links IRS Publication 590 For forms and other publications, see the IRS Web site.

• Your nondeductible contributions are always distributed first and you won't have to pay any taxes or penalties on these.
• The next to be distributed is any money converted to a Roth IRA from a traditional IRA — you will owe a 10 percent early withdrawal penalty on this.
• Next is money converted from a traditional IRA that was not taxable at the time of conversion. You won't pay taxes or penalties on this either.
• And, finally are earnings. You will owe taxes and the 10 percent early withdrawal penalty on this money unless you meet one of the exceptions under Internal Revenue Code Section 72(t).

You use IRS Form 8606 to report the distributions and calculate taxes. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.