Tax Treatment of IRA’s

Study Notes:

Roth IRAs and Roth 401Ks

In general, owners of IRAs do not generate taxable income on growth, dividends, interest, or capital
gains in the account. This is true for the entire IRA “family”. Purposely, I am going to dispense with Roth
IRAs and Roth 401Ks first. Since only after-tax contributions have been made, and assuming the 5-year
time limit from the funding of the Roth IRA has been met, any distributions after age 59.5 are not
taxable. Unlike traditional IRAs, there is no Required Minimum Distribution (RMD) at age 70.5 from
Roth IRAs. Roth 401Ks may be rolled over into a Roth IRA at retirement, and again distributions are not
taxable.

Beneficiaries are not taxed on Roth IRA distributions after the death of the owner and the 5-year time
limit for funding is waived. The inherited Roth IRA must be fully distributed by the end of the fifth year
following the death of the owner.

Traditional and SEP IRAs

Traditional and SEP IRAs do not generate taxable income to the owners as long as funds are held in the
account. Distributions must begin at age 70.5. RMDs are taxable as income to the owner when
received. Distributions are allowed after age 59.5 without penalty and are taxable. Distributions before
age 59.5 that were not taken in accordance with a hardship exception are subject to both income tax
and a 10% tax penalty.

There is a common misconception that 100% of all traditional IRA distributions are taxable, however this
is often not true. If after-tax funds (money on which taxes have already been paid) are contributed to a
traditional IRA, then the IRA has basis and the distribution is only partially taxable.

As after-tax contributions are made to a traditional IRA, they should be recorded on form 8606 in the
contributor’s 1040. This form “tracks” the basis so that when distributions are made a calculation of the
taxable portion can be made.

Charitable Option

Another opportunity exists for those over 70.5 to avoid taxation on IRA (and SEP) distributions. An IRA
owner can choose to contribute up to $100,000 in RMD to a charity of their choice (or multiple charities)
annually in lieu of taking the RMD. The distribution must be made directly to the charity from the
custodian. No income tax is due on the amount given to the charity (likewise no charitable deduction is
allowed).