Are Distributions Taxable?

In general, distributions from a traditional IRA are taxable in the year you receive them.

Failed financial institutions. This general rule applies to distributions made (with or without your consent) by a state agency as receiver of an insolvent savings institution. This means you must include such distributions in your gross income unless you can roll them over. For an exception to the 1-year waiting period rule for rollovers of certain distributions from failed financial institutions, see Exception under Rollover From One IRA Into Another, earlier.

Exceptions. Exceptions to the general rule are rollovers and tax-free withdrawals of contributions, discussed earlier, and the return of nondeductible contributions, discussed later under Distributions Fully or Partly Taxable.

Although a conversion of a traditional IRA is considered a rollover for Roth IRA purposes, it is not an exception to the general rule for distributions from a traditional IRA. Conversion distributions are includable in your gross income subject to these rules and the special rules for conversions explained in chapter 2.

Ordinary income. Distributions from traditional IRAs that you include in income are taxed as ordinary income.

No special treatment. In figuring your tax, you cannot use the 10-year tax option or capital gain treatment that applies to lump-sum distributions from qualified employer plans.

Distributions Fully or Partly Taxable

Distributions from your traditional IRA may be fully or partly taxable, depending on whether your IRA includes any nondeductible contributions.

Fully taxable. If only deductible contributions were made to your traditional IRA (or IRAs, if you have more than one), you have no basis in your IRA. Because you have no basis in your IRA, any distributions are fully taxable when received. See Reporting and Withholding Requirements for Taxable Amounts, later.

Partly taxable. If you made nondeductible contributions to any of your traditional IRAs, you have a cost basis (investment in the contract) equal to the amount of those contributions. These nondeductible contributions are not taxed when they are distributed to you. They are a return of your investment in your IRA.

Only the part of the distribution that represents nondeductible contributions (your cost basis) is tax free. If nondeductible contributions have been made, distributions consist partly of nondeductible contributions (basis) and partly of deductible contributions, earnings, and gains (if there are any). Until all of your basis has been distributed, each distribution is partly nontaxable and partly taxable.

Form 8606. You must complete Form 8606, and attach it to your return, if you receive a distribution from a traditional IRA and have ever made nondeductible contributions to any of your traditional IRAs. Using the form, you will figure the nontaxable distributions for 2001, and your total IRA basis for 2001 and earlier years. See the illustrated Forms 8606 in this chapter.

Note. If you are required to file Form 8606, but you are not required to file an income tax return, you still must file Form 8606. Complete Form 8606, sign it, and send it to the IRS at the time and place you would otherwise file an income tax return.

Figuring the Nontaxable and Taxable Amounts

If your traditional IRA includes nondeductible contributions and you received a distribution from it in 2001, you must use Form 8606 to figure how much of your 2001 IRA distribution is tax free.

Contribution and distribution in the same year. If you received a distribution in 2001 from a traditional IRA and you also made contributions to a traditional IRA for 2001 that may not be fully deductible because of the income limits, you can use Worksheet 1-1 to figure how much of your 2001 IRA distribution is tax free and how much is taxable. Then you can figure the amount of nondeductible contributions to report on Form 8606. Use the related instructions, under Reporting your nontaxable distribution on Form 8606, later, to figure your remaining basis after the distribution.

Form 8606 - Rose Green

Form 8606 - Page 2 - Rose Green

Filled-in Worksheet 1-1. Example of Figuring the Taxable Part of Your IRA Distribuiton

Reporting your nontaxable distribution on Form 8606. To report your nontaxable distribution and to figure the remaining basis in your traditional IRA after distributions, you must complete Worksheet 1-1 before completing Form 8606. Then follow these steps to complete Form 8606.

1. Use the worksheet in the Form 1040 or 1040A instructions to figure your deductible contributions to traditional IRAs to report on line 23 of Form 1040 or line 16 of Form 1040A.
2. After you complete the worksheet in the form instructions, enter your nondeductible contributions to traditional IRAs on line 1 of Form 8606.
3. Complete lines 2 through 5 of Form 8606.
4. If line 5 of Form 8606 is less than line 8 of Worksheet 1-1, complete lines 6 through 15 of Form 8606 and stop here.
5. If line 5 of Form 8606 is equal to or greater than line 8 of Worksheet 1-1, follow instructions 6 and 7, next. Do not complete lines 6 through 12 of Form 8606.
6. Enter the amount from line 8 of Worksheet 1-1 on line 13 of Form 8606.
7. Complete line 14 of Form 8606.
8. Enter the amount from line 9 of Worksheet 1-1 (or, if you entered an amount on line 11, the amount from that line) on line 15 of Form 8606.

Example. Rose Green has made the following contributions to her traditional IRAs.

In 2001, Rose, whose IRA deduction for that year may be reduced or eliminated, makes a $2,000 contribution that may be partly nondeductible. She also receives a distribution of $5,000 for conversion to a Roth IRA. She completed the conversion before 12/31/01 and did not recharacterize any contributions. At the end of 2001, the fair market values of her accounts, including earnings, total $20,000. She did not receive any tax-free distributions in earlier years. The amount she includes in income for 2001 is figured on Filled-in Worksheet 1-1, Example of Figuring the Taxable Part of Your IRA Distribution.

The Form 8606 for Rose, illustrated, shows the information required when you need to use Worksheet 1-1 to figure your nontaxable distribution. Assume that the amount used on line 1 of Form 8606 is the amount Rose figured using instructions 1 and 2 given earlier under Reporting your nontaxable distribution on Form 8606.

Recognizing Losses on IRA Investments

If you have a loss on your traditional IRA investment, you can recognize the loss on your income tax return, but only when all the amounts in all your traditional IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your traditional IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income limit that applies to certain miscellaneous itemized deductions on Schedule A, Form 1040. A similar rule applies to Roth IRAs. The rule applies separately to each kind of IRA. Thus, to report a loss in a Roth IRA, all the Roth IRAs (but not traditional IRAs) owned by you have to be liquidated, and to report a loss in a traditional IRA, all the traditional IRAs (but not Roth IRAs) owned by you have to be liquidated.

Example. Bill King has made nondeductible contributions to a traditional IRA totaling $2,000, giving him a basis at the end of 2000 of $2,000. By the end of 2001, his IRA earns $400 in interest income. In that year, Bill receives a distribution of $600 ($500 basis + $100 interest), reducing the value of his IRA to $1,800 ($2,000 + 400 - 600) at year's end. Bill figures the taxable part of the distribution and his remaining basis on Form 8606 (illustrated).

In 2002, Bill's IRA has a loss of $500. At the end of that year, Bill's IRA balance is $1,300 ($1,800 - 500). Bill's remaining basis in his IRA is $1,500 ($2,000 - 500). Bill receives the $1,300 balance remaining in the IRA. He can claim a loss for 2002 of $200 (the $1,500 basis minus the $1,300 distribution of the IRA balance). Bill completes Form 8606 as illustrated.

Form 8606 - Bill King $100

Form 8606 - Bill King $200

Inherited IRAs

The beneficiaries of a traditional IRA must include in their gross income any distributions they receive.

Beneficiaries. The beneficiaries of a traditional IRA can include an estate, dependents, and anyone the owner chooses to receive the benefits of the IRA after he or she dies.

Spouse. If you inherit an interest in a traditional IRA from your spouse, you can elect to treat the entire inherited interest as your own IRA as discussed under What If I Inherit an IRA, earlier. Also see the discussion earlier under When Must I Withdraw IRA Assets? (Required Distributions) for the rules on when you must begin to receive distributions from the IRA.

Beneficiary other than spouse. If you inherit a traditional IRA from someone other than your spouse, you cannot treat it as your own IRA. You cannot roll over any part of it or roll any amount over into it. You cannot make any contributions to an inherited traditional IRA.

IRA with basis. If you inherit a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. Unless you are the decedent's spouse and choose to treat the IRA as your own, you cannot combine this basis with any basis you have in your own traditional IRA(s) or any basis in traditional IRA(s) you inherited from other decedents. If you take a distribution from an inherited IRA and your IRA, and each has basis, you must complete separate Forms 8606 to determine the taxable and nontaxable portions of those distributions.

Federal estate tax deduction. A beneficiary may be able to claim a deduction for estate tax resulting from certain distributions from a traditional IRA. The beneficiary can deduct the estate tax paid on any part of a distribution that is income in respect of a decedent. He or she can take the deduction for the tax year the income is reported. For information on claiming this deduction, see Other Tax Information in Publication 559, Survivors, Executors, and Administrators.

Any taxable part of a distribution that is not income in respect of a decedent is a payment the beneficiary must include in income. However, the beneficiary cannot take any estate tax deduction for this part.

A surviving spouse can roll over the distribution to another traditional IRA and avoid including it in income for the year received.

Other Special IRA Distribution Situations

Two other special IRA distribution situations are discussed below.

Distribution of an annuity contract from your IRA account. You can tell the trustee or custodian of your traditional IRA account to use the amount in the account to buy an annuity contract for you. You are not taxed when you receive the annuity contract. You are taxed when you start receiving payments under that annuity contract.

Tax treatment. If only deductible contributions were made to your traditional IRA since it was set up (this includes all your traditional IRAs, if you have more than one), the annuity payments are fully taxable.

If any of your traditional IRAs include both deductible and nondeductible contributions, the annuity payments are taxed as explained earlier under Distributions Fully or Partly Taxable.

Cashing in retirement bonds. When you cash in retirement bonds, you are taxed on the entire amount you receive. Unless you have already cashed them in, you will be taxed on the entire value of your bonds in the year in which you reach age 70 1/2. The value of the bonds is the amount you would have received if you had cashed them in at the end of that year. When you later cash in the bonds, you will not be taxed again.

Reporting and Withholding Requirements for Taxable Amounts

If you receive a distribution from your traditional IRA, you will receive Form 1099-R, or a similar statement. IRA distributions are shown in boxes 1 and 2 of Form 1099-R. A number or letter code in box 7 tells you what type of distribution you received from your IRA.

Number codes. Some of the number codes are explained below. All the codes are explained in the instructions for recipients on Form 1099-R.

• 1--Early distribution, no known exception.
• 2--Early distribution, exception applies.
• 3--Disability.
• 4--Death.
• 5--Prohibited transaction.
• 7--Normal distribution.
• 8--Excess contributions plus earnings/
      excess deferrals (and/or earnings)
      taxable in 2001.

If code 1, 5, or 8 appears on your Form 1099-R, you are probably subject to a penalty. If code 1 appears, see Early Distributions, later. If code 5 appears, see Prohibited Transactions, later. If code 8 appears, see Excess Contributions, later.

Letter codes. Some of the letter codes are explained below. All the codes are explained in the instructions for recipients on Form 1099-R.

• D--Excess contributions plus earnings/
      excess deferrals taxable in 1999.
• G--Direct rollover to IRA.
• H--Direct rollover to qualified plan or tax-sheltered
      annuity or a transfer from a conduit IRA
      to a qualified plan.
• J--Early distribution from a Roth IRA, no known
      exception.
• N--Recharacterized IRA contribution made for 2001
      and recharacterized in 2001.
• P--Excess contributions plus earnings/
      excess deferrals taxable in 2000.
• R--Recharacterized IRA contribution made for 2000
      and recharacterized in 2001.
• S--Early distributions from a SIMPLE IRA in first
      2 years, no known exception.
• T--Roth IRA distribution, exception applies.

If the distribution shown on Form 1099-R is from your IRA, SEP-IRA, or SIMPLE IRA, the small box in box 7 (labeled IRA/SEP/SIMPLE) should be marked with an "X."

If code D, J, P, or S appears on your Form 1099-R, you are probably subject to a penalty. If code D appears, see Excess Contributions, later. If code J appears, see Early Distributions, later. If code P appears, see Excess Contributions, later. If code S appears, see Additional Tax on Early Distributions in chapter 4.

Withholding. Federal income tax is withheld from distributions from traditional IRAs unless you choose not to have tax withheld.

The amount of tax withheld from an annuity or a similar periodic payment is based on your marital status and the number of withholding allowances you claim on your withholding certificate (Form W-4P). If you have not filed a certificate, tax will be withheld as if you are a married individual claiming three withholding allowances.

Generally, tax will be withheld at a 10% rate on a nonperiodic distribution.

IRA distributions delivered outside the United States. In general, if you are a U.S. citizen or resident alien and your home address is outside the United States or its possessions, you cannot choose exemption from withholding on distributions from your traditional IRA.

To choose exemption from withholding, you must certify to the payer under penalties of perjury that you are not a U.S. citizen, a resident alien of the United States, or a tax-avoidance expatriate.

Even if this election is made, the payer must withhold tax at the rates prescribed for nonresident aliens.

More information. For more information, see Pensions and Annuities in chapter 1 of Publication 505, Tax Withholding and Estimated Tax. See also Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.

Reporting taxable distributions on your return. Report fully taxable distributions, including early distributions, on line 15b, Form 1040 (no entry is required on line 15a), or line 11b, Form 1040A. If only part of the distribution is taxable, enter the total amount on line 15a, Form 1040 (or line 11a, Form 1040A), and the taxable part on line 15b (or 11b). You cannot report distributions on Form 1040EZ.

Estate tax. Generally, the value of an annuity or other payment receivable by any beneficiary of a decedent's traditional IRA that represents the part of the purchase price contributed by the decedent (or by his or her former employer(s)), must be included in the decedent's gross estate. For more information, see the instructions for Schedule I, Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.

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