Back to Distributions


  • 3671. How are amounts distributed from a traditional IRA taxed?

    • Distributions from a traditional IRA generally are taxed under IRC section 72 (relating to the taxation of annuities).1 Under these rules, a portion of the distribution may be excludable from income. The amount excludable from the taxpayer’s income in a given year is that portion of the distribution that bears the same ratio to the amount received as the taxpayer’s investment in the contract (i.e., nondeductible contributions) bears to the expected return under the contract. In no case will the total amount excluded exceed the unrecovered investment in the contract.2

      All traditional IRAs are treated as one contract, all distributions during the year are treated as one distribution, and the value of the contract, income on the contract, and investment in the contract are computed as of the close of the calendar year with or within which the taxable year begins.3 Thus, the nontaxable portion of a distribution (whether from a traditional individual retirement annuity or account) is equal to the following:

      Unrecovered Nondeductible


         x    Distribution Amount

      Total IRA Account Balance +

      Distribution amount +

      Outstanding Rollovers

      The total IRA account balance is the balance in all traditional IRAs owned by the taxpayer, as of December 31 of the year of the distribution. The amount of any distributions made (i.e., the amounts for which the nontaxable portion is being computed) and any outstanding rollover amounts (i.e., any amount distributed by a traditional IRA within sixty days of the end of the year, which has not yet been rolled over into another plan, but which is rolled over in the following year) are added to the total IRA account balance. If it is not rolled over, the amount is not treated as an outstanding rollover.4

      Example: Bill King has made nondeductible contributions to a traditional IRA totaling $2,000, giving him a basis at the end of 2022 of $2,000. By the end of 2023, his IRA earns $400 in interest income. In that year, Bill receives a distribution of $600. Of the $600 received by Bill, the nontaxable portion of the distribution is equal to $500, calculated as follows:


      $2,000 [total unrecovered nondeductible contributions]

      x $600 [distribution amount]

      $2,400 [total IRA account balance + distribution]

      Thus, Bill will be taxed on only $100 of the $600 distribution and remaining IRA account balance will be $1,800 ($2,000+$400 – $600).

      Nondeductible contributions will not be excluded from gross income as investment in the contract where the taxpayer is unable to document the nontaxable basis through the filing of Form 8606, Nondeductible IRAs (Contributions, Distributions and Basis) for the year in which such nondeductible contributions were made and the year in which they were distributed (Q 3699).5

      An individual may recognize a loss on a traditional IRA, but only when all amounts have been distributed from all traditional IRAs and the total distributed is less than the individual’s unrecovered basis.6 The deduction for the loss was typically a miscellaneous itemized deduction (all of which were suspended for 2018-2025 by the 2017 tax reform legislation—the IRS has yet to issue guidance that would otherwise allow this loss deduction during this time period).7

      Despite the pro-rata rule generally applicable to distributions from a traditional IRA, distributions after 2001 that are rolled over to a qualified plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan are treated as coming first from all non-after-tax contributions and earnings in all of the IRAs of the owner.8 Because after-tax contributions cannot be rolled over to eligible retirement plans other than another IRA (Q 3996, Q 4004), this ordering rule effectively allows the owner to rollover the maximum amount permitted. Appropriate adjustments must be made in applying IRC Section 72 to other IRA distributions in the same taxable year and subsequent years.9

      The fact that IRA funds were distributed by the financial institution’s receiver following insolvency proceedings did not change the nature of the distribution. The taxpayers were taxed on the distribution since a timely rollover was not made.10

      Likewise, the transfer of IRA funds by a financial institution into a “trust account” was a taxable distribution to the taxpayer even though the taxpayer had intended to transfer the IRA funds to another IRA and had named the account a “trust IRA” because the money was transferred into the trust account.11

      In addition, a failed Roth IRA conversion that is not recharacterized is treated as a distribution from a traditional IRA and taxed accordingly (note that the typical Roth IRA recharacterization rules were eliminated for tax years beginning after 2017).12

      Taxpayers who were defrauded of their account balances by their investment advisor, who convinced them to make IRA rollover investments that the advisor subsequently embezzled, were liable for taxes on the amount of assets stolen because the account holders failed to take the necessary steps required to properly set up IRA rollover accounts.13

      Prior to 2018, special rules applied for qualified hurricane distributions, as follows: Unless a taxpayer elects otherwise, any amount of a qualified hurricane distribution required to be included in gross income shall be so included ratably over the three year taxable period beginning with such year.14

      If a qualified hurricane distribution is an eligible rollover distribution (Q 4004), it may be recontributed to an eligible rollover plan no later than three years from the day after such distribution was received (Q 4012).15

      Certain early distributions are subject to additional tax (Q 3677). As to what constitutes a “deemed distribution” from a traditional IRA, see Q 3649. For the estate tax marital deduction implications of distributions from a traditional IRA, see Q 3713.

      1. IRC Sec. 408(d)(1).

      2. IRC Sec. 72(b).

      3. IRC Sec. 408(d)(2).

      4. Notice 87-16, 1987-1 CB 446.

      5Alpern v. Comm., TC Memo 2000-246.

      6. Notice 87-16, 1987-1 CB 446.

      7. See IRS Pub 590-B (2015), p. 19.

      8. IRC Sec. 408(d)(3)(H).

      9. IRC Sec. 408(d)(3)(H)(ii)(III).

      10Aronson v. Comm., 98 TC 283 (1992).

      11. Let. Rul. 199901029.

      12. SCA 200148051.

      13. FSA 199933038.

      14. IRC Sec. 1400Q; Notice 2005-92, 2005-2 CB 1165.

      15. IRC Sec. 1400Q; Notice 2005-92, 2005-2 CB 1165.

  • 3672. Why is IRA basis important in determining the tax treatment of IRA distributions?

    • If an individual’s IRA contains basis, a portion of each distribution will represent basis and those amounts can be withdrawn from the account tax-free. If a taxpayer maintains multiple IRAs, the cumulative amount of nondeductible IRA contributions is used in determining the portion of a withdrawal from any particular account that is nontaxable.

      When clients think of IRA contribution limits, they generally think of the amount that the client may contribute and deduct from income (i.e., $6,000 in 2019-2022, $5,500 in 2018, with a $1,000 catch-up provision for clients age 50 and older). However, deductions are limited for those individuals whose income exceeds the annual inflation-adjusted thresholds.

      As a result, a taxpayer may make nondeductible contributions to an IRA even when his or her income is too high to qualify for a tax deduction. These nondeductible contributions represent the “basis” in the IRA, and are withdrawn tax-free (unlike traditional, deductible contributions, which are taxed under the general rules upon distribution). After-tax funds that are rolled over from another retirement account will also be added to the account’s basis.

      The Tax Court recently found that the bulk of a lump sum distribution received by a taxpayer was taxable even though the taxpayer was a high income taxpayer who would have been unable to deduct his IRA contributions. This is because the taxpayer was unable to produce documents that would prove the value of his basis in the account. Instead, the court relied upon Forms 5498 (Individual Retirement Arrangement Contribution Information) with respect to the taxpayer to limit his non-taxable distribution to the amount of nondeductible contributions that could be proven.1

      Individuals keep track of IRA basis on Form 8606, which must be filed with the IRS if the individual made any nondeductible contributions to an IRA for the year, or if he or she received a distribution from an account that has a basis that is greater than zero. Further, the form is required if the individual made a Roth IRA conversion (unless the entire amount was later recharacterized). Form 8606 must also be filed if the taxpayer receives a distribution or transfers funds from an inherited IRA that has basis.

      A $50 penalty applies for failure to file an annual Form 8606 when one is required, and a $100 penalty applies to individuals who overstate IRA basis.


      1. Shank v. Comm., No. 1752-17 (2018).

  • 3673. How are amounts distributed from a Roth IRA taxed?

    • “Qualified distributions” from a Roth IRA are not includable in gross income. Thus, earnings are tax-free, not tax deferred as with traditional IRAs. A “qualified distribution” is any distribution made after the five-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA (or such individual’s spouse made a contribution to a Roth IRA) established for such individual and such distribution meets one of the following requirements.1

      (1) It is made on or after the date on which the individual attains age 59½.

      (2) It is made to a beneficiary (or to the estate of the individual) on or after the death of the individual.

      (3) It is attributable to the individual’s being disabled (within the meaning of IRC section 72(m)(7)).

      (4) It is a “qualified first-time homebuyer distribution” (see below).

      A “qualified first-time homebuyer distribution” is any payment or distribution that is used within 120 days after the day it was received by the individual to pay the qualified acquisition costs of a principal residence for a first-time homebuyer.2 The aggregate amount of payments or distributions received by an individual from all Roth and traditional IRAs that may be treated as qualified first-time homebuyer distributions is limited to a lifetime maximum of $10,000.3 The first-time homebuyer may be the individual, his or her spouse, or any child, grandchild, parent, or other ancestor of the individual or his or her spouse. A first-time homebuyer is further defined as an individual (and, if married, such individual’s spouse) who has had no present ownership interest in a principal residence during the two year period ending on the date of acquisition of the residence for which the distribution is being made.4 The date of acquisition is the date on which a binding contract to acquire the residence is entered into or the date construction or reconstruction of the residence begins.5 Qualified acquisition costs are defined as the costs of acquiring, constructing, or reconstructing a residence, including reasonable settlement, financing, or other closing costs.6

      Planning Point: Although the first-time homebuyer exception allows a taxpayer to avoid paying taxes on earnings, an individual should consider the non-tax consequences of such a distribution. There is an “opportunity cost” associated with taking early distributions. By taking a distribution from a Roth IRA, the Roth funds are depleted and the individual could lose out on significant account growth over time.

      In calculating the five-taxable-year period, it is important to remember that contributions to Roth IRAs, as with traditional IRAs, may be made as late as the due date for filing the individual’s tax return for the year (without extensions) (Q 3655). For example, if a contribution is made to a Roth IRA between January 1, 2023 and April 15, 2023 for the 2022 taxable year, the five-taxable-year holding period begins to run in 2022.

      For purposes of determining whether a distribution from a Roth IRA that is allocable to a “qualified rollover contribution” (Q 3662) from a traditional IRA is a “qualified distribution,” the five-taxable-year period begins with the taxable year for which the conversion applies. A subsequent conversion will not start the running of a new five-taxable-year period.7

      The five-taxable-year period for determining a “qualified distribution” is not recalculated on the death of the Roth IRA owner; the five-taxable-year period of the beneficiary includes the period the Roth IRA was held by the decedent.8

      Any nonqualified distribution will be includable in income, but only to the extent that the distribution, along with all previous distributions from the Roth IRA, exceeds the aggregate amount of contributions to the Roth IRA. For this purpose, all Roth IRAs are aggregated. To the extent such distributions are taxable, the 10 percent early distribution penalty may apply (Q 3677). Distributions allocable to “qualified rollover contributions” (Q 3662) will be subject to the early distribution penalty regardless of whether the distribution is taxable if the distribution is made within the five-year period beginning with the tax year in which the contribution was made.9 Distributions of excess contributions and earnings on these contributions are not qualified distributions.10

      When a Roth IRA contains both contributions and conversion amounts, there are ordering rules that apply in determining which amounts are withdrawn. In applying the ordering rules, traditional IRAs are not aggregated with Roth IRAs. All Roth IRAs are aggregated with each other. Regular Roth IRA contributions are deemed to be withdrawn first, then converted amounts second (in order if there has been more than one conversion). Withdrawals of converted amounts are treated first as coming from converted amounts that were includable in income. The ordering rules treat earnings as being withdrawn last after contributions and converted amounts.11

      An individual may recognize a loss on a Roth IRA, but only when all amounts have been distributed from all Roth IRAs and the total distributed is less than the individual’s unrecovered Roth IRA contributions.12 The deduction for the loss was typically a miscellaneous itemized deduction, but all miscellaneous itemized deductions subject to the 2 percent floor were suspended
      for 2018-2025.13

      A transfer of a Roth IRA by gift would constitute an assignment of the Roth IRA, with the effect that the assets of the Roth IRA would be deemed to be distributed to the Roth IRA owner and, accordingly, treated as no longer held in a Roth IRA.14

      Prior to 2018, special rules applied for qualified hurricane distributions, as follows: Unless a taxpayer elects otherwise, any amount of a qualified hurricane distribution required to be included in gross income shall be so included ratably over the three year taxable period beginning with the year of distribution.15

      If a qualified hurricane distribution is an eligible rollover distribution Q 4004), it may be recontributed to an eligible rollover plan no later than three years from the day after such distribution was received (Q 4012).16

      For the estate tax marital deduction implications of distributions from a Roth IRA, see Q 3713.

      1. IRC Sec. 408A(d).

      2. IRC Sec. 72(t)(8)(A).

      3. IRC Sec. 72(t)(8)(B).

      4. IRC Sec. 72(t)(8)(D)(i).

      5. IRC Sec. 72(t)(8)(d)(iii).

      6. IRC Sec. 72(t)(8)(C).

      7. IRC Sec. 408A(d)(2)(B).

      8. Treas. Reg. §1.408A-6, A-7.

      9. Treas. Reg. §1.408A-6, A-5.

      10. See IRC Sec. 408A(d).

      11. IRC Sec. 408A(d)(4); Treas. Reg. §1.408A-6, A-8.

      12. Notice 87-16, 1987-1 CB 446.

      13. See IRS Pub 590-B (2015), p. 19.

      14. Treas. Reg. §1.408A-6, A-19.

      15. IRC Sec. 1400Q; Notice 2005-92, 2005-2 CB 1165.

      16. IRC Sec. 1400Q; Notice 2005-92, 2005-2 CB 1165.

  • 3674. Are the death proceeds of an individual retirement endowment contract taxable?

    • An endowment contract is a policy under which a person is paid a specified amount of money on a certain date unless he or she dies before that date, in which case, the money is paid to a designated beneficiary. Endowment proceeds paid in a lump sum at maturity are taxable only if the proceeds are more than the cost of the policy. To determine the cost, subtract any amount previously received under the contract, and exclude from income the total premiums (or other consideration) paid for the contract. Include the part of the lump sum payment that is more than the cost in income.1

      If no nondeductible contributions (Q 3656) have been made by the taxpayer to any traditional individual retirement plan, the portion of the death benefit of an endowment contract equal to the cash value immediately before death is included in gross income as a federal income taxable distribution. The balance is federal income tax-free as proceeds of life insurance under IRC Section 101(a). If the death benefit is paid in installments, the amount representing life insurance proceeds is prorated and recovered tax-free under IRC Section 101(d).2

      If nondeductible contributions to any such individual retirement plan have been made, it would seem that a portion of the cash value of the contract should be treated as a recovery of basis and, as such, nontaxable (Q 3671).

      1. IRS Pub. 17 (2019).

      2. Treas. Reg. §1.408-3(e)(2).

  • 3675. Are amounts received from IRAs subject to withholding?

    • Yes.

      Taxable distributions from traditional IRAs are subject to income tax withholding. If the distribution is in the form of an annuity or similar payments, amounts are withheld as though each distribution were a payment of wages pursuant to the recipient’s Form W-4. In the case of any other kind of distribution, a flat 10 percent must be withheld by the plan custodian unless a different withholding choice is elected by the owner.[1] A recipient generally can elect not to have the tax withheld; this election will continue until the recipient revokes the election.[2] Even though distributions from a traditional IRA may be partly nontaxable because of nondeductible contributions, the payor must report all withdrawn amounts to the IRS.[3] For states that impose income tax on IRA distributions, state income tax withholding may also be required.

      Planning Point: A recipient of a taxable IRA distribution should project his or her income tax liability for the year and pay in an appropriate amount of estimated tax payments to avoid penalties for under-withholding. Withholding of 10 percent or even 20 percent may be insufficient to cover federal income tax liability. Taxpayers should project their state and local tax liabilities as well. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC.

      Distributions from Roth IRAs are subject to income tax withholding, but only to the extent that it is reasonable to believe the amount withdrawn would be includable in income.[4]

      Planning Point: IRS withholding guidance, released in Notice 2018-14, could impact individuals who receive retirement benefits in the form of periodic payments (generally those that are annuitized). Individuals receiving periodic payments can use Form W-4P to waive or increase withholding, depending upon their expected income tax liability. With respect to periodic payments, the default method of withholding is based on whether the individual is single or married and the number of withholding allowances the individual could claim were the payments traditional wages. Under Notice 2018-14, the IRS has set the default withholding for periodic payments to equal the wage withholding of a married taxpayer who claims three withholding allowances in order to take the 2017 tax reform law into consideration. Individuals who receive periodic retirement payments may wish to examine their anticipated tax situation and use Form W-4P to modify this default treatment if appropriate. [5]

      Planning Point: Starting in 2022, withholding elections were to be divided among two forms, Form W-4P and Form W-4R.  The IRS has delayed the effective date to January 1, 2023.  The IRS has also released draft forms and instructions, encouraging individuals to begin using these forms in 2022, as soon as systems can be updated.  Form W-4P will be used for withholding tax from periodic payments made from retirement plans and IRAs (the default withholding will be single, with no adjustments, if the taxpayer fails to provide a form).  If the taxpayer is already receiving periodic payments, there’s no need to submit a new form if the taxpayer doesn’t wish to make any changes.  Form W-4R will be used to withhold federal tax from certain rollover distributions and non-periodic payments.[6]

      For 2020, the IRS redesigned Form W-4, which previously mirrored Form W-4P, to account for tax reform changes.  The IRS clarified that for 2020, the default rules for withholding from periodic payments under Section 3405(a) when no withholding certificate has been furnished will continue as in prior years (i.e., married with three allowances).

      IRS regulations clarify tax withholding rules for periodic retirement and annuity payments. Pre-tax reform, the default withholding rate was based on a married taxpayer with three withholding exemptions. Post-reform, the personal exemption has been suspended and Congress directed the Treasury to provide updated withholding rules.  The regulations add several Q&A to explain that amounts withheld will be treated as though the payment were part of wages paid by an employer.  If the payee has not provided a withholding certificate, the withholding amount is determined based on a married taxpayer with three withholding allowances.[7]

      Generally, withholding for these types of payments should be determined based on the rules in applicable IRS forms, instructions, publications and other guidance. Rules similar to the wage withholding rules will apply, but the IRS has indicated that further forms, instructions, publications and other guidance will be issued when the rules are finalized. The regulations apply to payments made after December 31, 2020.

      [1].     IRC Sec. 3405(e) (1)(A); Treas. Reg. §35.3405-1.

      [2].     IRC Secs. 3405(a) (2), 3405(b)(2).

      [3].     IRC Sec. 3405(e) (1)(B).

      [4].     IRC Sec. 3405(e) (1)(B).

      [5].     Notice 2018-14.

      [6]      The IRS draft forms can be found at–dft.pdf.

      [7].      Prop. Treas. Reg. §31.3405(a)-1.  See also Notice 2020-3.

  • 3676. What should taxpayers consider when determining their withholding for an IRA? Are taxpayers required to make estimated payments with respect to IRA distributions?

    • Taxpayers with IRA investments will face mandatory distributions (RMDs) from IRAs beginning April 1 of the year after the year the individual reaches age 72 (70½ before 2020). For those who have focused on accumulating retirement savings in traditional IRAs, this means that taxes will be due on all distributions at the individual’s ordinary income tax rate. Each taxpayer has optionswhen it comes to how those taxes will be paid, however. The individual may choose to make estimated income tax payments, which are due by April 15, June 15, September 15 and January 15 each year, or the account owner can choose to have his or her IRA custodian withhold taxes from each distribution (similarly to how the employer withholds from an employee paycheck).

      If the taxpayer chooses withholding, he or she does not have to determine the proper level of estimated payments, but should continue to calculate anticipated income each year in order to avoid under or over-withholding. The taxpayer is able to specify the exact percentage that he or she wishes to be withheld from each distribution, so the risk remains that the taxpayer will over or under pay throughout the year. Further, the IRS will assume that the amount withheld by the taxpayer was paid in equal installments over the year, but the taxpayer is able to make a single lump sum payment if advantageous. Taxpayers are also able to have a certain percentage withheld from each IRA distribution, but also make estimated payments in order to avoid the year-end tax hit.

      When an account owner converts traditional IRA funds to a Roth account, he or she is again liable for ordinary income tax on the amount converted. The taxpayer has the option of specifying the amount that should be withheld from the conversion (because each individual will have to anticipate income from other sources in order to determine his or her tax liability for the year). If the taxpayer fails to specify the percentage that should be withheld from the converted amount, the IRA custodian will withhold 10 percent as a default.

      Unfortunately, for taxpayers who convert to Roth accounts, the amount that is withdrawn to cover the amount that must be withheld will also be subject to tax—at ordinary income tax rates. This requires the taxpayer to take this into consideration when determining the withholding amount, which can be complex. In the case of a Roth conversion, therefore, it is generally in the taxpayer’s best interest to pay their tax liability on the distribution using funds outside of the IRA—potentially making the estimated payment route the more attractive option.

  • 3677. What penalties apply to early distributions from an IRA?

    • Except as noted below, amounts distributed from a traditional IRA or a Roth IRA to the individual for whom the plan is maintained before such individual reaches age 59½ are early (premature) distributions. To the extent such distributions are taxable, they are subject to an additional tax equal to 10 percent of the amount of the distribution that is includable in gross income for that particular tax year.1 The tax is increased to 25 percent in the case of distributions from SIMPLE IRAs (Q 3706) during the first two years of participation.2

      The 10 percent penalty tax does not apply to the following:

      (1) Distributions made to a beneficiary or the individual’s estate on or after the death of the individual.3

      Planning Point: If a surviving spouse is under age 59½ and elects to be treated as the owner of a decedent spouse’s IRA (generally, for required minimum distribution purposes), distributions may be subject to the early distribution penalty unless an exception applies. The early distribution penalty would not apply to distributions after the death of the original owner in the absence of the spouse making the election to be treated as owner.

      (2) Distributions attributable to the individual’s disability.4

      (3) Distributions made for medical care, but only to the extent allowable as a medical expense deduction for amounts paid during the taxable year for medical care (determined without regard to whether the individual itemizes).5 Thus, only amounts in excess of 10 percent of the individual’s adjusted gross income (“AGI”) escape the 10 percent penalty. (The threshold amount was 7.5 percent for tax years prior to 2013, and is again 7.5 percent for 2017-2020.)

      (4) Distributions made to unemployed individuals for the payment of health insurance premiums. The AGI floor, described above, does not have to be met if the individual has received unemployment compensation for at least twelve weeks and the withdrawal is made in either the year such unemployment compensation was received or the year immediately following the year in which the unemployment compensation was received. This exception also applies to self-employed individuals whose sole reason for not receiving unemployment compensation is that they were self-employed. The exception ceases to apply once the individual has been reemployed for a period of sixty days.6

      Planning Point: If an IRA owner pays health insurance premiums in a year of unemployment, and the owner expects to need an IRA distribution within the next few years at a time when the owner does not anticipate that any other exception will apply, the owner should consider taking an IRA distribution in the year of unemployment to avoid a future penalty tax on that amount. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC.

      (5) Distributions made to pay “qualified higher education expenses” during the taxable year for the taxpayer, the taxpayer’s spouse, or the child or grandchild of the taxpayer or the taxpayer’s spouse.7 “Qualified higher education expenses” means tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the student at any “eligible educational institution.” For tax years beginning after 2001, this includes expenses for special needs services in the case of a special needs beneficiary that are incurred in connection with such enrollment
      or attendance. Room and board (up to a certain amount) also is included if the student is enrolled at least half-time.8 “Qualified higher education expenses” must be incurred for the taxable year of the distribution.9 These expenses must be reduced by any scholarships received by the individual, any educational assistance provided to the individual, or any payment for such expenses (other than a gift, devise, bequest, or inheritance) that is excludable from gross income.10 An “eligible
      educational institution” is any college, university, vocational school, or other postsecondary
      educational institution described in Section 481 of the Higher Education Act of 1965.11 Thus, virtually all accredited public, nonprofit, and proprietary postsecondary institutions are considered eligible educational institutions.12 This exception to the 10 percent penalty is not available if the withdrawal qualifies for one of the other exceptions provided under IRC Section 72(t)(2) (other than the following exception for “qualified first-time homebuyers”).

      Planning Point: If an IRA owner has higher education expenses in a given year and he or she expects to need an IRA distribution within the next few years at a time when he or she does not anticipate that any other exception will apply, the IRA owner should consider taking an IRA distribution in the year of the higher education expenses to avoid a future penalty tax on that amount. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC.

      (6) Distributions that are “qualified first-time homebuyer distributions” (Q 3673). This exception to the 10 percent penalty is not available if the withdrawal qualifies for one of the other exceptions provided under IRC Section 72(t)(2).14

      (7) Distributions that are part of a series of substantially equal periodic payments made (at least annually) for the life or life expectancy of the individual or the joint lives or joint life expectancy of the individual and his or her designated beneficiary (Q 3679).15

      (8) Distributions that are “qualified hurricane distributions” (these distributions may not exceed $100,000).16 See Q 3794.01.

      (9) Distributions that are “qualified reservist distributions.” Qualified reservist distributions are those made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to return the amount of any distributions to the retirement plan for two years following the end of active duty.17

      The penalty tax has been held not to apply to compulsory distributions where the IRS levied on a taxpayer’s IRA and where the federal government seized a taxpayer’s IRA as part of a plea agreement.18

      Where a taxpayer withdrew from his IRA to satisfy a court order to pay alimony and child support, the penalty tax did apply.19

      No early distribution occurs where accumulation units in an individual retirement annuity are surrendered to purchase a disability waiver of premium feature.20 Ineligibility to set up an individual retirement plan does not prevent imposition of this penalty.21 The fact that an IRA distribution was mandated by the insolvency of the financial institution issuing the IRA did not prevent the application of the 10 percent penalty tax when the funds were received and not rolled over.22

      The amount reportable as an early distribution from a time deposit (such as a certificate of deposit) that is subject to an early withdrawal penalty of the trustee is the net amount of the distribution after deduction of any early withdrawal penalty imposed by the trustee.23

      It appears that amounts includable in income as a result of a prohibited transaction, borrowing on an annuity contract, or using an account as security for a loan would be subject to the 10 percent penalty.24

      1. IRC Sec. 72(t).

      2. IRC Sec. 72(t)(6).

      3. IRC Sec. 72(t)(2)(A)(ii).

      4. IRC Sec. 72(t)(2)(A)(iii).

      5. IRC Sec. 72(t)(2)(B).

      6. IRC Sec. 72(t)(2)(D).

      7. IRC Sec. 72(t)(2)(E).

      8. IRC Secs. 72(t)(7), 529(e)(3).

      9Lodder-Beckert v. Comm., TC Memo 2005-162 (2005).

      10. IRC Sec. 72(t)(7)(B).

      11. See IRC Sec. 529(e)(5).

      12. Notice 97-60, 1997-2 CB 310, at 14 (Sec. 3, A16).

      13. IRC Sec. 72(t)(2)(E).

      14. IRC Sec. 72(t)(2)(F).

      15. IRC Sec. 72(t)(2)(A)(iv).

      16. IRC Sec. 1400Q; Notice 2005-92, 2005-2 CB 1165.

      17. IRC Sec. 72(t)(2)(G).

      18Larotonda v. Comm., 89 TC 287 (1987), nonacq.; Murillo v. Comm., TC Memo 1998-13, aff’d. 166 F.3d 1201 (2nd Cir. 1998).

      19Baas v. Comm., TC Memo 2002-130. See also Czepiel v. Comm., TC Memo 1999-289, aff’d. by order (1st Cir. 2000).

      20. See Let. Rul. 7851087.

      21Orzechowski v. Comm., 69 TC 750 (1978), aff’d 79-1 USTC ¶7220 (2nd Cir. 1979).

      22Aronson v. Comm., 98 TC 283 (1992).

      23. Let. Ruls. 8643070 and 8642061.

      24. IRS Pub. 590-A (2019).

  • 3678. What strategies should a taxpayer consider when determining the level of distributions from retirement accounts during retirement?

    • Depending on a taxpayer’s unique circumstances, there are many different approaches that an advisor may take to help determine an appropriate or advantageous distribution level. Two traditional strategies that are commonly used are the “4 percent rule” (see below) and the RMD method, which uses the IRS’s required minimum distribution rules to make the determination.

      The RMD rules (Q 3682) require that taxpayers begin withdrawing funds from tax-deferred retirement accounts, such as IRAs and 401(k)s, when they reach age 72 The minimum amounts that must be withdrawn are calculated based on the taxpayer’s life expectancy, determined using IRS actuarial data.1

      The IRS provides tables specifying the percentage of current account assets that must be withdrawn each year based on the life expectancy of the taxpayer in any given year after reaching age 72 (tables are also available for taxpayers beginning withdrawals at younger ages). In the case of a married couple where one spouse is more than ten years younger than the other, the joint life expectancy of the couple is used in the calculation to provide a more realistic estimate of the combined life expectancy of the couple.2

      The RMD requirements are generally not meant to provide retirees with guidance on the optimal withdrawal rate, but are meant to ensure that the funds in these tax-deferred accounts are used for retirement income, rather than as estate planning vehicles. Because the requirements seek to ensure that the assets are spent during life, they are a viable alternative to the so-called “4 percent rule,” even though this was not the original IRS intent in formulating the rules.

      As the name suggests, under the 4 percent rule, the taxpayer withdraws 4 percent of the beginning balance of retirement savings each year during retirement. While the rule is very simple, it can have unintended consequences. For example, the rigid 4 percent-per-year requirement tends to encourage taxpayers to seek out dividend-heavy investments to supplement their otherwise fixed income, regardless of whether those investments are otherwise appropriate.

      Further, the 4 percent rule has taxpayers withdraw 4 percent even in years when their assets may have severely underperformed. The converse is also true, as the rule limits taxpayers to 4 percent withdrawals even if they could afford much more.

      Some advisors find that the RMD method should be considered as a potential alternative to the traditional 4 percent rule for determining retirement account withdrawal rates. Not only is the RMD approach almost as simple as the 4 percent rule—rather than withdrawing 4 percent each year, the taxpayer would consult the IRS tables to determine the applicable percentage—but it offers much more flexibility.

      The RMD rule may be, in many ways, much more realistic than the 4 percent rule because it bases withdrawals on the current value of the taxpayer’s retirement assets. While this requires determining the account values each year, it also allows taxpayers to modify their consumption levels based on actual account performance. Because the percentages are based on life expectancy and vary with age, it is still unlikely that the taxpayer will outlive his assets.

      1. IRC Secs. 408(a)(6), 408(b)(3), 401(a)(9).

      2. Treas. Reg. §1.401(a)(9)-9.

  • 3679. How are substantially equal periodic payments from an IRA calculated for purposes of IRC Section 72(t)?

    • The 10 percent early (premature) distribution tax (Q 3677) does not apply to distributions that are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the individual or the joint lives or joint life expectancy of the individual and his or her designated beneficiary.1

      The IRS has approved three methods, explained below, under which payments will be considered to be “substantially equal periodic payments.”2 Regardless of which method is used, the series of payments must continue for the longer of five years or until the individual reaches age 59½. Ordinarily, a “modification” (see Q 3680) that occurs before this duration requirement is satisfied will result in the penalty and interest being imposed on the entire series of payments, in the year the modification occurs.3 However, a participant can (see Q 3680) change methods one time if certain requirements are met.4 A change in the payment series as a result of disability or death also does not trigger the penalty.5

      The three approved methods are as follows:

      1.   The Required Minimum Distribution (“RMD”) method: requires use of a calculation that would be acceptable for purposes of calculating the required minimum distributions under IRC Section 401(a)(9). Consequently, annual payments are determined each year by dividing the account balance by the owner’s current life expectancy obtained from one of three IRS tables (see below). Under this method, the account balance, the life expectancy, and the resulting annual payments are redetermined each year and can cause a variation in the payment from year to year. Such annual fluctuations will not be considered modifications.6 Under this method, the same life expectancy table used for the first distribution year must be used for each following year.7 Although the Worker, Retiree and Employer Recovery Act of 2008 (“WRERA 2008”) waived RMDs for 2009, this did not apply for purposes of the substantially equal periodic payment exception to the early distribution penalty.8

      2.   The fixed amortization method: requires annual payments determined by amortizing the individual’s account balance in level amounts over a specified number of years determined using the chosen life expectancy and interest rate as explained below.9 The account balance, life expectancy, and resulting annual payment are determined once for the first distribution year, and the annual payment is the same amount in each year thereafter.10 The ability to recalculate the amount of the payment each year by using the taxpayer’s life expectancy with the amortization method was approved in a letter ruling.11

      3.   The fixed annuitization method requires annual payments determined by dividing the individual’s account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the individual’s age attained in the first distribution year and continuing for the life of the individual (or the joint lives of the individual and a beneficiary). The annuity factor is derived using the mortality table provided in a 2002 IRS guidance and an interest rate chosen as explained below. The account balance, annuity factor, interest rate, and resulting annual payment
      all are determined once for the first distribution year and the annual payment is the same amount each year thereafter.12 The ability to recalculate the amount of the payment each year by using the taxpayer’s life expectancy with the annuitization method was approved in a letter ruling.

      The three life expectancy tables that may be used to calculate substantially equal periodic payments are: the single life expectancy table, the joint and last survivor life expectancy table, and the uniform lifetime table.14 (Because the uniform lifetime table in the RMD regulations begins at age seventy, the IRS included an expanded version covering a broader range of ages.)15 All three tables are reproduced in Appendix F – 01. The IRS has announced that, beginning in 2022, taxpayers with existing distribution schedules may switch to the updated life expectancy tables without modifying the distribution.16  

      For the amortization method, an interest rate must be used that does not exceed 120 percent of the federal mid-term rate (determined in accordance with IRC Section 1274(d)) for either of the two months immediately preceding the month in which the distribution begins.17  Beginning in 2022 and thereafter, the IRS has announced that taxpayers can use an interest rate that is not more than the greater of (1) 5% or (2) 120% of the federal mid-term rate for either of the two months immediately preceding the month in which the distribution begins.18  Beginning in 2022 and thereafter, the IRS has announced that taxpayers can use an interest rate that is not more than the greater of (1) 5% or (2) 120% of the federal mid-term rate for either of the two months immediately preceding the month in which the distribution begins. Notice 2022-6.


      Planning Point: The RMD method is the simplest calculation, but will need to be recalculated every year. The amortization and annuitization calculations are more complex, but only need to be performed once.

      The IRS has stated that individual retirement plans do not have to be aggregated for purposes of calculating a series of substantially equal periodic payments.19 If a taxpayer owns more than one IRA, any combination of the IRAs may be taken into account in determining the distributions by aggregating the account balances of those IRAs. But a portion of one or more of the IRAs may not be excluded to limit the periodic payment to a predetermined amount.20

      Planning Point: The ability to split up or aggregate IRAs in advance of a payout makes the calculation extremely flexible. Furthermore, creating separate accounts is a good way to avoid tying up any more IRA funds than is absolutely necessary to support the needed payout.

      If an individual with more than one IRA chooses to base a series of substantially equal periodic payments on the total of all of his or her IRAs, the annual distribution may be received from any or all of the accounts.21

      Planning Point: It generally is useful to select the substantially equal periodic payment method that comes closest to withdrawing the amount that is desired. Under the amortization or annuitization  methods, higher interest rates result in higher payments; lower interest rates result in lower payments. In general, having a designated beneficiary can reduce the amount of the payments (calculations can be based on two lives rather than one); a younger beneficiary results in lower payments, an older beneficiary results in higher payments. Selecting IRA accounts with a lower aggregate account balance results in lower payments; selecting IRA accounts with a higher aggregate account balance results in higher payments.

      1. IRC Sec. 72(t)(2)(A)(iv).

      2. Rev. Rul. 2002-62, 2002-2 CB 710, modifying Notice 89-25, 1989-1 CB 662, A-12.

      3. IRC Sec. 72(t)(4).

      4. Rev. Rul. 2002-62, 2002-2 CB 710.

      5. IRC Sec. 72(t)(4).

      6. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(a).

      7. Rev. Rul. 2002-62, 2002-4 CB 710, Sec. 2.02(a).

      8. Notice 2009-82, 2009-2 CB 491.

      9. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(b).

      10. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(b).

      11. Let. Rul. 200432021.

      12. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.01(c).

      13. Let. Rul. 200432023.

      14. See Rev. Rul. 2002-62 and Treas. Reg. §1.401(a)(9)-9.

      15. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.02(a).

      16. Notice 2022-6.

      17. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.02(c).

      18. Notice 2022-6.

      19. See Let. Ruls. 200309028, 9050030.

      20. Let. Rul. 9705033.

      21. See Let. Rul. 9705033.

  • 3680. When is a series of substantially equal periodic payments from an IRA “modified” and what are the results?

    • Except in the event of death or disability, a change in payouts after the series has begun generally will constitute a “modification” and will trigger the early distribution penalties discussed in Q 3677.1

      A modification to the series of payments generally will occur if the taxpayer makes any of the following: (1) any addition to the account balance (other than gains or losses); (2) any nontaxable transfer of a portion of the account balance to another retirement plan; or (3) a rollover of the amount received, resulting in such amount not being taxable.2

      The IRS has determined that a change that does not alter the annual payout (such as a change from quarterly to monthly payments) is not a modification for this purpose.3 The receipt of a qualified hurricane distribution (Q 3671) also will not be treated as a change in a series of substantially equal periodic payments.4 However, once a change to the RMD method has been elected, no further changes may be made to the method of payment.

      The IRS has stated that an individual who begins distributions using either the amortization method or the annuitization method may, in any subsequent year, switch to the RMD method to determine the payment for the year of the switch and all subsequent years. Regardless of when the payments began, a taxpayer making such a change will not be treated as having made a “modification.”5

      Planning Point: The ability to switch to the RMD method makes the amortization and annuity methods more attractive, particularly for a participant who has a short term need for larger distributions
      which he or she expects will diminish in a few years. Martin Silfen, J.D., Brown Brothers, Harriman Trust Co., LLC, New York, New York.

      A taxpayer who made the one-time RMD method change late in 2002 was permitted to roll over amounts in excess of the RMD amount back to the IRA in early 2003 even though the sixty day limit (Q 4016) had elapsed.6 The IRS determined that an inadvertent rollover of a small IRA balance into a large IRA from which a series of substantially equal periodic payments was in progress was not a modification.7

      The IRS has also ruled that a series of substantially equal periodic payments was not modified where, as a result of an error made by the entity distributing the funds, additional distributions were made by the entity from a second account maintained by the taxpayer before the funds from the first account were exhausted. This resulted in two additional, unrequested distributions. The taxpayer was able to provide proof that the error was made after the entity maintaining the account was acquired by another entity. She further certified that she had not requested the additional distributions and did not intend to modify the series of substantially equal periodic payments. As a result, the IRS found that the additional distributions were not a modification of the series of substantially equal periodic payments.8

      Planning Point: Qualified plans often make a trailing distribution subsequent to making a lump sum distribution to a former employee’s IRA. The IRS currently holds the position that if the participant has started a 72(t) payout from the receiving IRA, the trailing distribution will trigger a modification. Participants starting a 72(t) payout following a lump sum distribution should consider moving the funds to a different IRA prior to beginning the payout. Robert S. Keebler, CPA, MST, Virchow, Krause & Company, LLP, Green Bay, Wisconsin.

      The commencement of another series of substantially equal periodic payments (i.e., from a different IRA) does not constitute a modification of an existing payout, and the IRS has stated privately that nothing in the IRC or regulations prevents a subsequent payout series.9 One case determined that a distribution from an IRA that satisfied the early distribution penalty exception for qualified higher education expenses was not a modification of a series of substantially equal periodic payments from the same IRA.10

      1. IRC Sec. 72(t)(4).

      2. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.02(e).

      3. See Let. Rul. 8919052.

      4. Notice 2005-92, 2005-2 CB 1165, Sec. 4H.

      5. Rev. Rul. 2002-62, 2002-2 CB 710, Sec. 2.03(b).

      6. Let. Rul. 200419031.

      7. See Let. Rul. 200616046.

      8. Let. Rul. 201510060.

      9. See Let. Rul. 200033048.

      10Benz v. Comm., 132 TC 330 (2009).

  • 3681. What are the results if an IRA account owner depletes the IRA account through properly pre-determined substantially equal periodic payments?

    • The penalty under IRC Section 72(t) will not be applied if, as a result of applying an acceptable method of determining substantially equal periodic payments, an individual depletes his or her account and is unable to complete the payouts for the required duration period under IRC Section 72(t)(4).1

      1. Rev. Rul. 2002-62, 2002-2 CB 710, Secs. 2.03(a) and 3.