Additionally, I touched briefly on how to manage transfers, rollovers and withdrawals. Basically, up to this point, the focus has been maximizing accumulation of funds. In this article, I will shift my focus to the opposite aspect – minimizing tax liability – to ensure IRA owners preserve maximum distributions from retirement funds.
Here are few points that IRA owners must know to handle retirement account taxation and to avoid potential tax pitfalls.
1. The IRS taxes all distributions as ordinary income at withdrawal. The form of investment gains in the IRA, such as capital gains, qualified dividends, municipal bond interest, return of capital, etc., is irrelevant. Roth IRAs (RIRAs) are the only exceptions because IRA owners fund RIRAs with after-tax contributions.
a. Progressive tax-table rates apply to ordinary income. I will use 2017 tax brackets and rates for my example. After all deductions, those married filing jointly pay 10% on the first $18,560 of ordinary income, 15% on ordinary income between $18,651 and $75,900, 25% on ordinary income between $75,901 and $153,100 and so on. Please note that these brackets and tax rates will change significantly for 2018, once the Tax Cuts and Jobs Act goes into effect.
2. After-tax contributions are contributions that the IRA owner does not deduct in the year of the contribution. Any of these after-tax contributions that the IRA owner directly contributes to the Traditional IRA (TIRA) or holds in a retirement plan rolled over to a TIRA, are the only sources of after tax dollars (basis) held in a TIRA.
a. Withdrawals from a TIRA with basis are prorated, as directed by Part I of form 8606. For example, if 10% of one’s TIRA(s) is basis, then 10% of the withdrawal from the TIRA is a return of basis and is free of taxes.
3. Unrelated Business Taxable Income (UBTI)
a. UBTI is income from direct investment in for-profit business ventures, income from margin trading or income from use of a non-recourse loan in an IRA. Please note that the use of a prohibited transaction of the IRA as collateral for a loan does not prevent an IRA from taking a loan, as long as the IRA balance is not at risk of loss. Therefore, the IRS does not regard non-recourse loans as prohibited transactions.
b. The most common source of UBTI for IRA owners are units of Master Limited Partnerships (MLPs) traded on the major stock exchanges.
i. If income from the MLP – or combination of all MLPs held by the IRA – is greater than $1,000 per IRA per year, the IRA – not the IRA owner – pays the income tax at corporate tax rates.
c. UBTI does not treat the invested assets as a distribution and the earnings subject to taxation do not form a basis in the IRA.
4. Any applicable 10% early withdrawal penalty is in addition to the tax paid on the withdrawal and the IRA owner must use IRS form 5329 to report it.
5. Securities sold in a taxable account at a loss by the IRA owner or the spouse, and repurchased in an owner’s IRA or the spouse’s IRA, within plus or minus 30 days of the loss sale, will be considered a “wash sale,” which will disallow the loss.
a. Securities sold at a loss in an IRA may not be treated as a loss for income tax purposes.
6. If a Roth IRA (RIRA), or a combination of all RIRAs that the owner might have, has a market value less than the total of past contributions, the account owner may close the RIRA(s) and take a loss on that year’s tax return.
a. The IRA owner must itemize deductions as the loss must be taken as a miscellaneous itemized deduction subject to the 2% Adjusted Gross Income (AGI) floor. Note: this deduction has been repealed under the Tax Cuts and Jobs Act beginning in 2018.
b. If the withdrawn amount is not put back into the IRA or another IRA within 60 days, the RIRA owner may not replace the withdrawn amount, but may only thereafter make normal annual contributions or eligible TIRA conversions.
c. The owner must restart the five-year holding period for future RIRA qualified withdrawals.
7. At death, the assets in the IRA – mutual funds, stocks, partnership units, etc. – do not step-up in basis as such investments held in a taxable account usually would. These investments remain taxable as ordinary income upon withdrawal by beneficiaries, unless the beneficiary is a qualifying charity.
8. Savers Credit:
a. Savers Credit is a direct tax credit for moderate-to-low income individuals who contribute to their IRA or an employer retirement plan.
b. This credit is for those aged 18 or older who are not full-time students and are not claimed as a dependent on a tax return by another person.
c. The credit amount is reported on form 8880.
d. See IRS publication 4703 for specific details and eligibility.
9. The IRA owner may direct the custodian to withhold and send to the IRS estimated tax amounts from TIRA withdrawals with either elective or regular periodic distributions. The percent withhold options will vary by custodian.
10. Net Unrealized Appreciation (NUA)
a. An employer retirement plan that contains employer stock will usually give the employee the option to transfer the company stock to a taxable account upon retirement, if the employee is at least age 59.5, and roll over the remainder of the retirement plan balance directly to a TIRA or convert it to a RIRA.
b. If an IRA owner contributes company stock to the retirement plan over their working years, and upon retirement the employee wishes to exercise the NUA option, he or she must declare the fair value of that stock transferred to a taxable account out of the retirement plan as ordinary income for that year. However, when the stock is eventually sold by the retired employee or his/her beneficiaries at death, the appreciated value of the stock will be long-term capital gains. That is, the Net Unrealized Appreciation of the inherited stock do not step-up their basis at the death of the owner. The primary reason to exercise the NUA option is because Capital gains usually have more favorable tax rates than the retiree’s tax bracket for ordinary income.
11. Tax Withholdings
a. If instructed by the IRA owner, the IRA custodians will generally withhold and send to the IRS a percentage of an IRA withdrawal. It does not make any difference whether that withdrawal is elective or mandatory.
b. The IRS considers all tax withholdings withdrawn equally over the year even if there is only one annual withholding in December.
These are just basic points about taxation of IRA withdrawals. As I have done for previous topics, I will use a few tax-related questions from past customers in my next article to offer some answers about specific tax problems. I hope my answers will help to provide guidance about which options are available to IRA owners in similar situations.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.