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Understanding the tax treatment of retirement plan distributions is commonly required when preparing a tax return. It is therefore covered in numerous questions on the IRS exam for tax preparers.
Most distributions from retirement plans are not taxable when withdrawals occur during retirement. However, there are often situations where taxpayers conduct withdrawals from retirement accounts that are taxed. Anyone who has become a tax preparer will frequently encounter taxpayers with early distributions from retirement plans.
Some taxpayers are not fully aware of the income tax effect from withdrawing funds from retirement accounts. This can cause them to have insufficient withholding during the year to cover their tax liability. Therefore, tax class information about estimated tax penalties can also apply when addressing retirement plan distributions.
In most cases, early distributions from retirement plans occur when the taxpayer has not reached age 59�. Although there are some exceptions, early distributions are normally subject to a 10 percent tax penalty in addition to regular income tax. Distributions that are rolled over to another qualified retirement account are not subject to tax or the penalty. However, a rollover must occur within 60 days of a distribution.
Even early distributions from a Roth IRA incur the 10 percent penalty, unless an exception is met. Such withdrawals from a Roth IRA are also subject to regular income tax. Roth IRA distributions only avoid tax and the 10 percent penalty when they are returns of original invested funds, qualified distributions, or made pursuant to one of the exceptions. An important part of tax preparer jobs is knowing the exceptions related to disability, first time home purchase, medical costs, or higher educational expenditures.
Like all amounts withdrawn from retirement accounts, early distributions are reported to the IRS by the payers. The amounts are reported on a Form 1099-R. Taxpayers also receive a copy of this form.
Training for the tax preparer exam teaches the calculations required to determine partially taxable early distributions from retirement plans. For example, a taxpayer with nondeductible contributions in an IRA is not taxed on the percentage of distributions represented by those nondeductible amounts. Only after-tax contributions to other types of retirement plans result in partially non-taxable early distributions.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
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