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George F. Bearup, J.D. Senior Legal Trust Advisor

20-Oct-20

Taxable and Non-Taxable Distributions from Retirement Plans

Take-Away: Most distributions from retirement accounts are taxed as ordinary income. However, there are several situations defined in the Tax Code when the distribution from a retirement account will not be subject to immediate income taxation.

Background: As a general rule, distributions from a retirement plan are taxable as ordinary income to the participant whose qualified plan account is the source, or in the case of distributions after a participant’s death to the beneficiary who is entitled to the distribution. [IRC 402(a).] The same for distributions from IRAs. [IRC 408(d)(1).]

Exceptions to the General Rule of Taxation of Retirement Account Distributions: However, the Tax Code provides several situations when a distribution from a retirement account or IRA is not completely taxable as ordinary income to the recipient.

  • Roth Accounts: Qualified distributions from Roth IRAs are tax-free, if the funds have remained in the Roth IRA a sufficient period of time. [408A(d)(1).]
  • Rollovers: A distribution can be rolled over income  tax-free to the same or another retirement plan if various requirements are met for rollovers, including rollovers by a participant subject to the 60-day limit[IRC 402 (c)(1)], rollovers by a surviving spouse to his or her own retirement account,  [408(d)(3)(C)] and rollovers by other beneficiaries.
  • Life Insurance: A distribution of life insurance from a qualified plan after the insured participant dies are partly income tax-free; the return of the tax basis in the life insurance policy, i.e. that part of the annual premium that is taxed to the participant-insured, is income tax-free when the death benefit is paid. [IRC 72(m)(3) and IRC 402(a).]
  • Annuities: A distributions of an annuity contract, either to the participant or to the beneficiary is not taxable if the annuity contract complies with the required minimum distribution rules and the annuity is non-assignable by the recipient. [Treasury Regulation 1.402(a)(1)(a)(2).]
  • Recovery of Basis: If non-deductible contributions to a retirement plan or IRA are made, those non-deductible contributions are basis that is not taxable when distributed, although the formula used to calculate the non-taxable portion can be confusing to administer. [IRC 72(b)(2).]
  • Return of IRA Contributions: Special income tax rules apply for IRA contributions that are returned to the contributor, e.g. an excess contribution to the IRA. [IRC 408(d)(5)(A) and IRC 408(d)(4).]
  • Estate Taxed Retirement Distributions: A beneficiary who takes a distribution from an inherited retirement account or IRA is entitled to an income tax deduction for the federal estate taxes paid attributable to the decedent’s retirement benefits. [IRC 691(c)(2)(B).]
  • Charities: If the beneficiary is income tax-exempt, it does not have to pay income tax on the distribution. [IRC 501(c)(3); IRC 170(a) and (c)(2)(A).] If a private foundation is the beneficiary, a distribution to it is not taxed as gross investment income of the foundation, and thus not subject to the 2% tax on unrelated business taxable income.
  • Qualified Domestic Relations Orders (QDROs): A transfer of a retirement account incident to a divorce [IRC 402(e)(1), IRC 414(p) and IRC 408(d)(6).]
  • Qualified Health Savings Accounts: IRA owners are giving a once-in-a-lifetime transfer of funds from their own IRA, income tax-free to a health saving account (HSA.) [IRC 408(d)(9).] Note that this opportunity from an IRA does not increase the maximum amount that can be contributed to the HSA. [IRC 408(d)(9)(E).]
  • Octogenarians: Part of a qualified retirement plan’s lump sum distribution of benefits to individual participants who were born before January 2, 1936 are eligible for a reduced tax rates: (i) a 20% capital gains method is used in part; and (ii) a special 10-year averaging method can also be used. [IRC 402(d)(3) and IRC 62(a)(8).]
  • Employer Securities: A lump sum distribution of employer stock from a participant’s qualified retirement plan on termination of employment is eligible for deferred taxation at long-term capital gains rates, and not subject to immediate income taxation. [IRC 402(e)(4)(E).]

Conclusion: The Tax Code’s general rule of taxation  provides that “except as otherwise provided in IRC 401(a,) any amount actually distributed to any distributee by any employees’ trust described in section 401(a) shall be taxable to the distributee in the taxable year of the distributee in which distributed under section 72 (relating to annuities.) [IRC 402(a) and 408(d)(1).] Often overlooked is the except as otherwise provided language which seems to create several exceptions to this general rule of income taxation.