Retirement Income Blog

Once you’ve reached age 70½, you must take a minimum required IRA distribution (MRD) each year.  But if you don’t need the cash to live on and you expect your IRA stock to increase in the future, consider taking an ‘in kind’ IRA distribution for improved tax benefits.

Recent economic conditions have hit many equities hard. Their lowered values have lowered the value of the IRA they’re in. Since this year’s MRD is based on possibly a higher IRA value at the end of previous year, you will pay tax on an irritatingly large MRD for 2008.  To mitigate this, IRS has waived the 2009 MRD requirement altogether. 

Equities – such as stocks – you bought in your IRA have a ‘zero’ tax basis. Whatever value you take out for your IRA distributions is taxed at ordinary income tax rates. And that includes all gains those equities made. Also,  there’s no deduction for any loss within an IRA.

Keeping those depressed equities in your IRA for a possible comeback within a year or two will have you paying ordinary income tax rates when you take them out in the future for both their value and any gains. That’s a bad tax consequence of IRAs for appreciating equities.

Take an In Kind IRA distribution for reduced taxation

But if you expect those equities to appreciate, you have to withdraw your MRD, and you don’t need the cash for living, you can capitalize on that future growth at a much lower capital gains tax rate.  Do this by taking an ‘in kind’ IRA distribution.

You take an ‘in kind’ IRA distribution by requesting your IRA custodian to transfer the stock directly from your IRA account to a taxable account without cashing them in. Keep records on the value of that stock when it’s transferred. It’s on that value that you’ll have to pay ordinary income tax as an IRA distribution. You’ll have to come up with cash elsewhere to pay this tax.

But that stock value now becomes the basis of that transferred stock. If the stock appreciates three better tax consequences occur:

• Any gain will be subject to the low long term capital gains tax – and that’s for gain above its new basis. 
• You’ll not have to pay any tax on any gain until you wish to sell it.
• Dividends will be tax yearly – but if they’re qualified dividends, you pay at no more than the 15% rate (current rate in effect for 2009 and 2010)

Lastly, if the equities fall further and you decide their not worth holding for the future, you’ll be able to take a capital loss deduction and use it to offset other tax on other income or IRA distributions.

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Generally, your IRA and or company 401(k) distributions are taxed as ordinary income. That’s because you funded them with tax-deductible contributions and all the earnings of these contributions have been tax-deferred. So nothing has been taxed. Taking a distribution before turning 59½ will add a 10% penalty tax to the income tax.

Nevertheless, you may have made some ‘after-tax’ contributions to them, and those – not their earnings – will come out tax free. So let’s see how this to handle these.

Taxable and non taxable distributions for company-administered plans such as a 401(k)
This is pretty easy because it’s your employer who is responsible for tracking both your tax deductible and after-tax contributions to the plan. They’ll report those amounts to you, either on your statements or on a 1099-R when you take a distribution from the plan. 

IRA distribution
You’re the administrator of your IRA. So keeping track of after-tax contributions is your job. That’s done on IRS Form 8606 each year you make an after-tax contribution and each year you take an IRA distribution.

This form – each time it’s filed - carries forward the total of prior year after-tax contributions and adds them to any current year contribution. It also formulates the non-taxable portion of any distribution you take in the year. And, of course subtracts out that amount from the total after-tax contributions among your IRAs.  Normally, form 8606 is attached to your tax return. 

The non-taxable portion of your IRA distributionsduring the year is the ratio of all your after-tax contributions (from your latest Form 8606) divided by the total value of your IRAs. No, you don’t get to take out just the ‘tax-free’ part!  Each time you take an IRA distribution, part is taxable, part is return of after tax money (not taxable).

What if you forgot to file your Form 8606 over the years? Just get the form and its instructions; it’ll give you some suggestions on documentation you can use to substantiate your prior after-tax contribution amounts.  If you think the amount of after tax contributions you have forgot to document is significant, then get help form a tax professional so that you don’t need to pay tax twice when you take distributions.

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