Distributions from Individual Retirement Accounts and Exceptions

Many distributions are taxed but some are not

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An individual retirement account, commonly called an IRA, is a retirement plan provided by many financial institutions. These accounts offer some significant tax advantages for retirement savings, but they're not all the same. Different types of IRAs include traditional, Roth, SEP, and SIMPLE plans, and the rules can be marginally different for each. 

Types of IRAS

A traditional IRA is the one most people think of when they hear the term.

In many cases and subject to certain limitations, you're entitled to a tax deduction for contributions you make to a traditional IRA plan.

You can't claim a tax deduction for contributions you make to a Roth IRA plan, but you don't have to pay taxes on any distributions you take after retirement age, either. Distributions from a traditional IRA are typically considered taxable income because of those tax deductions you took. 

A SIMPLE IRA—an acronym for Savings Incentive Match Plan for Employees—is provided by an employer. It allows employees to make pre-tax contributions from their paychecks. If you're paid $1,000 a week and you contribute $25 to your SIMPLE IRA, you would only pay taxes on $975 because that $25 is deducted before taxes are calculated on the balance. But these distributions are taxable as well when you retire and take money out.  

"SEP" IRA stands for Simplified Employee Pension and this type of plan is available to self-employed individuals.

The Basics About IRAs

Some general rules apply to all IRAs. Money that you take out of the account is called a distribution, and distributions are included on your tax return as taxable income in most cases. They're treated as ordinary income, taxable at your marginal tax rate. In general, distributions from a traditional IRA are taxable in the year you receive them.

You can be hit with an additional 10 percent tax penalty if you take a distribution before the age of 59 1/2. The flip side of this is that you must begin taking distributions after age 70 1/2. 

But what if you move the funds from one IRA to another? This is known as a "rollover," not a distribution. 

The One-a-Year Rule for IRA Rollovers

You can make only one rollover from an IRA to another IRA account in any one-year period, no matter how many IRAs you own. But you can make unlimited trustee-to-trustee transfers between IRAs, or transfers from plan administrator to plan administrator, because this type of transfer is not considered a rollover.

A rollover occurs when you get involved as the middleman, effectively taking possession of the money before transferring it to another account, even for a short period of time. When the funds go directly from one institution to another, or one account to another without your involvement, no taxes come due. 

Some Exceptions to the Rule 

There's no limit on the number of rollovers you can make from a traditional IRA to a Roth IRA. These transfers are known as conversions.

Certain types of distributions from defined benefit plans paid to airline employees can be rolled over to traditional IRAs without tax consequences.

And if you participate in a SIMPLE IRA, you can roll funds from other group retirement plans, such as 401(k) plans and traditional IRAs, into your SIMPLE IRA two years after you first began participating in the plan. 

Other Distributions That Qualify for Tax-Exempt Treatment

Distributions can be exempt from taxation in some other situations as well—they don't have to be included in your gross income. 

  • That one rollover that you're permitted per year is not taxable in that year. 
  • You can take a distribution after age 70 1/2 and give it to a qualified charitable organization tax-free, but this rule does not apply to SEP or SIMPLE IRAs.
  • Distributions from Roth IRAs become tax-free if the IRA is at least five years old and you've reached age 59 1/2. You can also take Roth IRA distributions tax-free if you're younger than age 59 1/2 if you're doing so to buy a first-time home or due to disability. 
  • You can take a distribution and transfer it to a Health Savings Account one time.