Income Tax Rules for Retirement Plans

Income Tax Rules for Retirement Plans

For those of you who participate in retirement plans such as 401(k), 403(b), Roth IRA, SEP IRA, traditional IRA, understanding income tax rules is very important.  Let's cover a few common rules that generally apply to all retirement plans:

Distributions become taxable immediately upon withdrawal

The amount of any distributions for a particular tax year from your retirement plan will be taxed in your current tax bracket.  There is an exception to this rule which states that if you roll your distribution into another retirement plan within a 60 day window, taxes will not be charged.  Secondly, if your employer transfers the distributions directly into another retirement account, these distributions will be considered tax exempt. 

Keep in mind that starting in 2008, you will be allowed to transfer qualified plan assets into a Roth IRA; this is commonly known as a Roth IRA conversion.  If you elect to go down this route, you will be responsible for paying income tax on the transferred assets at your current tax rate; however, at retirement, no taxes will be due on the principal or any gains. 

Investment Losses Cannot Be Deducted or Claimed

This is a confusing topic for some.  Investment losses within an IRA can NOT be claimed or deducted on your tax returns.  However, distribution will be taxed at your current tax rate.  For example, if you contribute $10,000 into an IRA and that investment is currently only worth $5,000, then you will be taxed on the $5,000 distribution you take.  Now, some of you might say, I lost money on this investment; why should I owe taxes? 

You may only claim a loss on your tax return if you made nondeductible contributions to that account.  In the case where you made deductible contributions (such as in the case of a 401(k) or traditional IRA), you were never charged any tax upfront so you will owe taxes on any monies withdrawn at retirement, whether it is higher or lower than the contribution that was initially made.  This actually is a fair process.  In reality, if you lose money, your tax burden is lowered.  For example, in our situation above, if $10,000 was contributed in 1990 (no taxes paid) and that investment became $5,000 at when a distribution was made at retirement, you have essentially avoided paying taxes on the $10,000 contribution you made pre-tax.  You are now only paying taxes on $5,000 at a presumably lower interest rate.  Either way, you win. 

There is one exception to the rule.  In the case of a nondeductible IRA such as a Roth IRA where your aggregate cost basis (or total contribution amount across all nondeductible IRAs) exceeds the aggregate value of all your nondeductible accounts at final distribution, you are entitled to claim the loss on your tax return.  The reason the IRS deals in aggregates is due to the fact that you may make a boatload of money on one account and lose in another and it would not be equitable if deductions were taken for losses that were only isolated to one account, when in reality, an aggregate gain was made.

Cash Withdrawal is Not Mandatory

You may choose which assets you wish to withdraw, whether it be cash or non-cash assets such as stock.  When withdrawn, your cost basis on the non-cash asset distribution will be the value of the asset at time of withdrawal.  For example, suppose you purchased Motorola stock in your IRA for $5 per share over the years.  Now, the stock is worth $10.  If you start taking withdrawals of stock rather than cash, your basis will be $10.  When you actually sell the stock, you will owe taxes on the difference between the sales price and your basis.

Retirement Plan Contributions are Not Taxable 

Retirement plan contributions, or Basis, is not taxable when making distributions at retirement.  Different plan types warrant different rules when it comes to distribution of the basis.  For example, Keoghs or traditional IRAs have a pro-rata distribution technique of taxation which will derive a ratio of your basis (or total plan contributions) to total account value and then apply this ratio to the distribution to determine taxable gains.  For example, assume you contributed $20,000 to your IRA over the years and the fair market value of the account is at $100,000 at year end.  You also withdrew $10,000 for the year.

Taxable Distribution = (1 - (Basis / Fair Market Value at Year End)) * Distribution Amount

In our scenario the formula would read like this:  (1 - .2) * $10,000 = $8,000

You would have to report $8,000 in income on your tax return.

Divorce & Inheritance

Retirement assets acquired through divorce or inheritance are subject all the rules we listed above here.  Basis and tax burden will be as if you were the original owner. 


Tim Ord
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