In the last post we talked about the benefits of an IRA – whether Traditional or Roth – the difference between the two, and then we talked about contributions. In this section we’ll talk about distributions and tax reporting.

IRA Distribution Rules

An IRA owner may take a distribution – also referred to as a withdrawal – at any time. The general process goes something like this:

• IRA owner contacts the financial institution to make a distribution

• The financial institution documents the distribution on a withdrawal instruction form

• IRA owner receives the money

• The financial institution reports the distribution information to the IRS and the IRA owner

• IRA owner documents distribution on their tax return (if applicable)

There are two types of taxes that an IRA owner may be assessed, depending on when the distribution is taken.

1. Income tax (federal and possibly state)
2. Early distribution tax (penalty)

It is the financial institutions responsibility to report the distribution correctly to the IRA owner and the IRS. It is the IRA owner’s responsibility to determine the taxable portion of each distribution and pay any taxes due. Your financial institution is not a tax service, in most cases, so they may not know the answer to any questions you have regarding this. If you’re unsure of what the taxable portion of your distribution is, it is best to speak with your tax advisor.

Federal Withholding

This seems to be the question that gets asked the most when people make a withdrawal from their IRAs. Just what is that 10% withholding?

Your financial institution is required to withhold 10% for federal taxes on all IRA distributions that may be subject to income tax, unless the owner or beneficiary specifically elects no withholding. In most cases, this election must be done in writing. If the owner does not indicate their preference, the financial institution is supposed to withhold 10%. However, the financial institution should be notifying owners of their right to withhold or waive withholding on a distribution.

Now, as you will recall, an IRA is counted as pre-tax dollars which means it’s not taxed going in. You get to take the total contribution amount off your income taxes for that year. So, that money is then taxed on it’s way out. In an effort to help prevent people having to pay a large chunk come tax time, the IRS implemented this 10% withholding to give the IRA owner the opportunity to pre-pay some of the taxes that will be due on the distribution.

The IRS does allow IRA owners to withhold more than 10% if they wish; however, tax law does not provide owners the right to withhold less than 10%, unless they choose no withholding. In Texas I don’t see a lot of people withholding more than the 10%; however, for those of you who have state taxes as well, withholding more than 10% is a good way to cover both federal and state taxes on the distribution, or at least a portion of both.

Early Distribution Tax (Penalty)

In general, an IRA owner under the age of 59 1/2 who chooses to make a distribution from their IRA is subject to a 10% early distribution tax on the portion withdrawn. According to IRS tax rules, a person turns 50 1/2 exactly six months after their 59th birthday. So, for example, let’s say you were born November 12, 1950. You would turn 59 on November 12, 2009. However, you would still be subject to the 10% early withdrawal penalty until May 12, 2010…when you officially turn 59 1/2.

The early distribution tax only applies to the taxable portion of the IRA distribution, which may not necessarily include the entire amount of withdrawal. You should see your tax advisor with any specific questions related to that, though.

This tax is not the same as the 10% withheld for federal income taxes, either. This is completely different. It’s also not collected by the financial institution. You would pay this tax when filing your income tax return, and there is a form you would complete and file with your return, as well.

As with most anything, there are some exceptions to the penalty tax. You would avoid paying the early distribution tax if the withdrawal was made for one of the following reasons:

• Owner is deceased and the funds are being paid to the beneficiary

• Owner is disabled

• Funds distributed to the federal government in response to a federal tax levy

• Owner is receiving substantially equal payments over their life expectancy (pre-59 1/2 periodic payments)

• Owner direct transferred traditional IRA funds to a Roth IRA

• Owner rolled over traditional IRA funds to a Roth IRA

• Owner has qualified higher-education expenses

• Owner has qualified first-time home purchase expenses

• Owner has qualified unreimbursed medical expenses greater than 7.5% of adjusted gross income

• Owner is paying qualified health insurance premiums while unemployed for 12 weeks or longer

• Owner has a qualified reservist distribution

As you can see, this list of exceptions is pretty varied. Of course, it goes without saying that if you’re over the age of 59 1/2, these wouldn’t apply to you as the penalty tax no longer applies to you. But, I figure I should mention it, just in case there was some confusion. Also note that most financial institutions do not notate the distribution for these exceptions (except disability). You will have to let your tax preparer know at the end of the year that you had a qualified distribution so they can make the appropriate adjustments. Again, keeping up with your IRA is your responsibility. The financial institution merely reports whether a contribution or distribution was made. They do not police the specifics of an IRA.

Any distribution requests should be handled in writing with the withdrawal reason marked. Most financial institutions will have their own forms that they require. This form will also have a place for you to elect whether you would like withholding or not. At any rate, the institution needs your signature prior to making the distribution, so be sure you’ve looked over the form and checked for any potential errors.

Tax Reporting Requirements

Financial institutions are required to report contributions and distributions to both the IRS and IRA owners. For your contributions you should receive IRS Form 5498, or an acceptable substitute. For distributions, you should receive IRS Form 1099-R, or an acceptable substitute.

IRS Form 5498 is not type-specific, meaning that both Roth and traditional IRA contributions are reported using this form; however, those with both a Roth and a traditional will receive a separate 5498 for each one.

The deadline for the 5498 to be mailed to the IRA owner and the IRS is May 31st of the following year as contributions are allowed to be made until April 15th of the following year. If May 31st falls on a weekend or a federal holiday, then the deadline moves to the next business day. If you do not make contributions for the year, then you won’t receive this form. And, since the financial institution reports to both you and the IRS, you don’t have to send the 5498 in with your federal tax return.

The 1099-R is used to report distributions that took place for the year and you will receive one 1099-R for each distribution with a different reason code. So, for example, if you have three distributions total for the year and two of them were due to disability and one was due to a federal tax levy, then you’ll receive two 1099-R’s because you have two different reason codes. This applies regardless of the number of investments sheltered under the IRA umbrella as it goes by the distribution reason code.

Your financial institution is required to mail the 1099-R to the IRA owner by January 31st; however, it is extremely important for you to update your address records with your bank so that you receive this document in a timely manner. My credit union had a mass influx of return mail on our 1099s this year because people hadn’t updated their address, then they turn around and get mad at us because they didn’t receive it. We don’t know if you’ve moved, so please update addresses!

The only time you have to include the 1099-R with your federal tax return is when you’ve had federal withholding. I’m not really sure why this is since financial institutions also send a copy of the 1099-R to the IRS, but those are the rules and I just pass them along. I’m guessing this is for those early filers since financial institutions aren’t required to have the forms to the IRS until March 31st. But, that’s just a guess.

So, there are the basics of IRAs. Hopefully that answers some questions or motivates you to get started on your retirement. I didn’t talk about state filing with IRAs because I don’t know the first thing about it. We don’t have state tax here in Texas, so it’s not something I deal with. If you do have state tax, I recommend visiting your tax advisor. But, remember, you can still contribute to your IRA for the 2008 tax year until April 15th.

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