Plan Distributions and Taxation
Understanding distribution rules, taxation, and penalties is crucial for Series 7 representatives helping clients access their retirement savings appropriately.
General Distribution Taxation
Qualified Plan and Traditional IRA Distributions
Distributions from qualified plans and Traditional IRAs are taxed as ordinary income because:
- Contributions were made pre-tax (or tax-deductible)
- Earnings grew tax-deferred
- No taxes have been paid yet
Example: A $50,000 distribution from a 401(k) is fully taxable as ordinary income in the year received.
Roth Distributions
Qualified Roth distributions are tax-free because:
- Contributions were made after-tax
- Earnings grew tax-free
- All taxes have been paid
Non-qualified Roth distributions: Earnings may be taxable and subject to penalties.
The 10% Early Withdrawal Penalty
Distributions before age 59½ from retirement accounts generally trigger a 10% penalty in addition to ordinary income tax.
Accounts Subject to Early Withdrawal Penalty
| Account Type | 10% Penalty Applies? |
|---|---|
| Traditional IRA | Yes |
| Roth IRA (earnings) | Yes |
| 401(k) | Yes |
| 403(b) | Yes |
| 457 | No |
Key Point: 457 plans do not impose the 10% early withdrawal penalty, making them uniquely flexible.
Penalty Exceptions
The 10% penalty does NOT apply in these situations:
Universal Exceptions (All Accounts)
| Exception | Description |
|---|---|
| Death | Distributions to beneficiaries |
| Disability | Total and permanent disability |
| Substantially Equal Payments | 72(t) distributions |
| IRS Levy | Funds seized to satisfy tax debt |
| Qualified Disaster | FEMA-declared disaster relief |
IRA-Only Exceptions
| Exception | Description |
|---|---|
| First Home Purchase | Up to $10,000 lifetime |
| Higher Education | Qualified education expenses |
| Health Insurance (Unemployed) | 12+ consecutive weeks unemployed |
| Medical Expenses | Exceeding 7.5% of AGI |
Employer Plan-Only Exceptions
| Exception | Description |
|---|---|
| Separation from Service (Age 55) | Leave job at age 55+ |
| Qualified Domestic Relations Order | QDRO distributions |
| Dividends from ESOP | Pass-through dividends |
Key Point: The "Rule of 55" only applies to employer plans, not IRAs. You must leave your job in or after the year you turn 55.
Required Minimum Distributions (RMDs)
RMD Age Requirements
| Account Type | RMD Start Age |
|---|---|
| Traditional IRA | 73 |
| 401(k), 403(b) | 73 |
| Roth IRA | None during owner's lifetime |
| Inherited IRAs | Special rules apply |
Future Change: RMD age increases to 75 starting in 2033.
RMD Timing Rules
| Situation | Deadline |
|---|---|
| First RMD | April 1 of year after turning 73 |
| Subsequent RMDs | December 31 each year |
| Still Working Exception | Can delay employer plan RMD if still employed (not 5%+ owner) |
Warning: Delaying the first RMD to April 1 means taking TWO RMDs in one year—potentially pushing you into a higher tax bracket.
RMD Calculation
RMD = Account Balance (Dec. 31 prior year) ÷ Life Expectancy Factor
Life expectancy factors come from IRS Uniform Lifetime Table (or Joint Life Table if spouse is 10+ years younger).
Example: Account balance: $500,000; Life expectancy factor at age 73: 26.5 RMD = $500,000 ÷ 26.5 = $18,868
RMD Penalty
Failure to take the full RMD results in:
| Penalty | Rate |
|---|---|
| Standard Penalty | 25% of shortfall |
| Corrected Within 2 Years | Reduced to 10% |
Example: Required RMD is $20,000; only $15,000 withdrawn Shortfall = $5,000 Penalty = $5,000 × 25% = $1,250 (or $500 if corrected within 2 years)
Qualified Charitable Distributions (QCDs)
Individuals age 70½+ can make Qualified Charitable Distributions directly from their IRA to charity:
| Feature | Detail |
|---|---|
| Maximum | $108,000 per year (2025) |
| Tax Treatment | Excluded from income |
| RMD Satisfaction | Counts toward RMD |
| Charitable Deduction | Cannot also deduct |
Benefit: QCDs reduce taxable income even if you don't itemize deductions.
Rollovers Between Plan Types
Permitted Rollovers
| From | To Traditional IRA | To Roth IRA | To Employer Plan |
|---|---|---|---|
| Traditional IRA | Yes | Yes (taxable) | Yes (if plan allows) |
| Roth IRA | No | Yes | Yes (if plan allows) |
| 401(k)/403(b) | Yes | Yes (taxable) | Yes |
| 457 | Yes | Yes (taxable) | Yes |
Roth Conversions
Converting from Traditional to Roth:
- Taxable: Full amount included in income
- No Penalty: Conversion itself is not penalized
- Strategy: May convert in low-income years
- 5-Year Rule: Converted amounts have own 5-year clock for penalty-free withdrawal
Net Unrealized Appreciation (NUA)
NUA is a tax strategy for employer stock in qualified plans:
| Feature | Description |
|---|---|
| What It Is | Appreciation on employer stock while in plan |
| Tax Treatment | NUA taxed as long-term capital gain when stock sold |
| Requirement | Must take lump-sum distribution |
| Cost Basis | Taxed as ordinary income at distribution |
Example: Stock purchased at $20,000 in 401(k), now worth $100,000
- Cost basis ($20,000): Taxed as ordinary income at distribution
- NUA ($80,000): Taxed as long-term capital gain when sold
Key Point: NUA can save significant taxes versus rolling the stock into an IRA where all gains would be ordinary income.
On the Exam
The Series 7 exam frequently tests:
- Early withdrawal penalty exceptions
- RMD ages and calculation concepts
- Roth vs. Traditional taxation
- Rollover rules between plan types
- QCD requirements and benefits
A 45-year-old takes a $30,000 distribution from her 401(k) to pay for her daughter's college tuition. What are the tax consequences?
An individual turns 73 in 2025. By what date must they take their first Required Minimum Distribution?
What is the penalty for failing to take the full required minimum distribution from a Traditional IRA?
A 58-year-old employee leaves their company and wants to access their 401(k) without penalty. Under which circumstance could they avoid the 10% early withdrawal penalty?
A 72-year-old wants to donate $50,000 from her Traditional IRA directly to charity. Which statement is TRUE about this Qualified Charitable Distribution (QCD)?
11.1 The Primary Market
Chapter 11: Securities Markets & Trading