How Is My Retirement Distribution Taxed?

undefinedBy Kelly M. Walsh

The tax treatment on retirement accounts is complicated, and there are a lot of pitfalls. Many a well-intentioned taxpayer takes an early distribution from a retirement account to make ends meet, pay off debts, or settle a divorce only to be hit with more tax obligations than anticipated. The tax consequences of a distribution from a retirement account depends on factors including the type of retirement account, the character of the distribution, and your age.

In most cases, the determination whether you are required to pay income tax on a distribution from a retirement account is whether the contributions you made to the retirement account were made with pre-tax dollars or post-tax dollars. This is typically determined by the type of account. Most retirement accounts are funded with pre-tax dollars. Your income as reported on your W-2 is actually reduced by the amount of your retirement contributions. In those cases, because you did not pay tax when you put the money into the account, you must pay income tax when you take the money out. There are retirement accounts, such as Roth IRA accounts, that are funded with post-tax dollars, though. You pay tax on the funds before you deposit them in your retirement account, so you are not required to pay tax on the distribution.

Another important factor is the character of the distribution. An early distribution from a retirement account is typically a taxable event. However, it may be possible to meet the same goal of obtaining immediate funds by taking a loan from your retirement account without incurring income tax consequences. Keep in mind, though, that if you leave the employer that facilitated that retirement account and loan, the loan may be recharacterized as a taxable early distribution upon your termination from employment. If it is your intention to transfer the funds to another retirement account, you may avoid tax consequences using a rollover, so long as the funds are not removed from the first retirement account for more than 60 days. If it is your intention to transfer the funds to another person, there may be a variety of options available to you, such as through careful estate planning or a qualified domestic relations order in a divorce case, which may avoid tax consequences to you.

In addition to the basic income tax consequences, an early distribution from a retirement account is subject to a 10% penalty. This occurs when you make the distribution before you reach 59 ½ years of age for most retirement accounts. There are a number of exceptions, though, and a qualified tax professional may be able to help you avoid this penalty if you made the distribution for an expense that qualifies for exemption, such as distributions for unreimbursed medical expenses, upon total and permanent disability, to qualified military reservists called to active duty, and in some cases for qualified higher education expenses or qualified first-time homebuying expenses.

If you would like to discuss tax consequences of a distribution from a retirement account, preparing your income taxes, challenging an IRS assessment, or any other related matter, please contact our office to schedule a consultation.



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