Traditional, SEP, and SIMPLE IRAs are generally funded with pre-tax money, and therefore distributions are taxable as ordinary income in the year of distribution. A penalty may apply, in addition to ordinary income tax, for distributions from these IRAs if the IRA owner has not reached age 59½ or does not have an IRS-approved penalty exception. Penalty exceptions include: death, disability, military reservists called to active duty, qualified higher education expenses, medical insurance, healthcare savings account (HSA) rollovers, first-time home buyer ($10,000 lifetime limit), within one year of the birth or adoption of a child, other IRA or retirement plan rollovers, substantially equal periodic payments (Rule 72(t)), and unreimbursed medical expenses.
TRADITIONAL AND SEP IRA DISTRIBUTIONS
As previously stated, distributions from these IRA types are generally taxable as ordinary income. A 10% penalty will also apply on the withdrawal if the IRA owner has not yet reached age 59½ or does not have an IRS-approved penalty exception. Traditional and SEP IRAs are 100% vested immediately, so distributions can be taken at any age and for any reason. Required minimum distributions (RMDs) begin at age 73 even if the IRA owner is still working.*
SIMPLE IRA DISTRIBUTIONS
As previously stated, distributions from SIMPLE IRAs are generally taxable as ordinary income. A 25% penalty will also apply on the withdrawal if the IRA owner has not yet reached age 59½ and is within the first two years of SIMPLE IRA participation. After two years from the first SIMPLE IRA contribution date, the penalty is reduced down to 10% if the individual is under age 59½. Once the individual reaches age 59½, no penalty applies; however, the distribution is still taxable as ordinary income. SIMPLE IRAs are 100% vested immediately, so distributions can be taken at any age and for any reason. RMDs begin at age 73 even if the IRA owner is still working.*
AFTER-TAX ASSETS IN AN IRA
If an IRA owner has after-tax assets rolled into a traditional, SEP, or SIMPLE IRA from a retirement plan, or makes non-deductible contributions to a traditional or SEP IRA, the IRA owner is responsible for tracking any after-tax dollars, as well as the ratio of after-tax versus pre-tax balances in all IRA accounts under his or her Social Security number. After an IRA owner’s death, beneficiaries must continue the tracking process until the IRA assets are completely distributed. After-tax reporting is carried out by filing IRS Form 8606, Nondeductible IRAs, which gets attached to the individual’s 1040 tax return. Form 8606 must be submitted to the IRS every year in which there is a change in the after-tax basis (e.g., non-deductible contribution, after-tax rollover, conversion, or distribution). Once after-tax dollars are deposited into an IRA, IRA owners are not permitted to distribute only the after-tax amounts from any of their IRAs. A formula called the pro rata rule must be applied to each distribution to determine the taxable and non-taxable portion.
AFTER-TAX DISTRIBUTION EXAMPLE
An IRA owner has a total of $50,000 in all IRAs, which consists of $47,000 pre-tax and $3,000 after-tax. The after-tax amount is 6% of the total ($3,000 divided by $50,000 = 6%). If this IRA owner takes a distribution of $4,000, the after-tax portion equals $240 ($4,000 X 6% = $240) and the taxable portion equals $3,760 ($4,000 X 94% = $3,760). This procedure must continue for every distribution taken and requires IRS Form 8606 to be filed.
AFTER-TAX ROLLOVERS FROM RETIREMENT PLANS
Plan participants are permitted to directly roll the pre-tax portion of their account balance into a traditional IRA, and the after-tax portion (including Roth 401(k) and after-tax voluntary contributions) to a Roth IRA upon a triggering event. By choosing this strategy, after-tax tracking is eliminated and the tax-free assets continue to shelter new tax-free growth. Each retirement plan with pre-tax and after-tax assets will be distributed using a pro rata formula with the exception of pre-1987 after-tax contributions.
* For those who reached age 72 in 2022 or prior, RMDs continue from that age requirement.
Stifel does not offer tax advice. You should consult with your tax advisor regarding your particular situation as it pertains to tax matters.