10.5 Plan Distributions and Taxation
Key Takeaways
- Traditional plan and IRA distributions are taxed as ordinary income; qualified Roth distributions are tax-free.
- A 10% early-withdrawal penalty applies before 59 1/2 except for listed exceptions; 457(b) plans have no penalty.
- The Rule of 55 waives the penalty for employer-plan money when you separate from service at 55+ (not IRAs).
- RMDs begin at 73; a missed RMD now costs 25% of the shortfall (10% if timely corrected).
- QCDs (age 70 1/2+, up to $111,000 in 2026) and NUA on employer stock are key tax-saving distribution strategies.
How Distributions Are Taxed
Money coming out of qualified plans and Traditional IRAs is taxed as ordinary income — never capital gains — because the contributions went in pre-tax and the growth was tax-deferred. A $50,000 distribution from a 401(k) is $50,000 of ordinary income in the year received. A qualified Roth distribution is fully tax-free because contributions were after-tax and earnings grew tax-free. A non-qualified Roth distribution can make the earnings portion taxable and penalized.
The 10% Early-Withdrawal Penalty
Distributions before age 59 1/2 generally trigger a 10% penalty on top of ordinary income tax. The exam loves testing which accounts and situations escape it.
| Account | 10% penalty before 59 1/2? |
|---|---|
| Traditional IRA | Yes |
| Roth IRA (earnings only) | Yes |
| 401(k) | Yes |
| 403(b) | Yes |
| 457(b) governmental | No |
Penalty exceptions
Apply to all accounts: death, total/permanent disability, substantially equal periodic payments (Rule 72(t)), IRS levy, and federally declared disasters.
IRA-only exceptions: first-home purchase (up to $10,000 lifetime), qualified higher-education expenses, health insurance while unemployed 12+ weeks, and unreimbursed medical expenses above 7.5% of AGI.
Employer-plan-only exceptions: the Rule of 55 (penalty-free if you separate from service in or after the year you turn 55 — age 50 for certain public-safety workers), QDRO payments to an ex-spouse, and ESOP dividends.
A frequent trap: a 45-year-old taps a 401(k) for college tuition and owes the penalty, because the education exception applies only to IRAs, not employer plans. Even when the penalty is waived, the distribution is still ordinary income.
Required Minimum Distributions
RMDs force tax-deferred money out so it eventually gets taxed. They begin at age 73 for Traditional IRAs and most employer plans (rising to 75 in 2033). Roth IRAs have no RMDs for the owner during life.
| Timing rule | Deadline |
|---|---|
| First RMD | April 1 of the year after turning 73 |
| Each subsequent RMD | December 31 of that year |
| Still-working exception | May delay an employer-plan RMD if still employed and not a 5%+ owner |
Deferring the first RMD to April 1 means two RMDs in one calendar year, which can push the retiree into a higher bracket.
Calculating the RMD
RMD = Prior-Year-End Account Balance / Life-Expectancy Factor (from the IRS Uniform Lifetime Table, or the Joint Life Table when a spouse is more than 10 years younger).
Example: $500,000 balance / 26.5 factor at age 73 = $18,868 RMD.
Penalty for a missed RMD
| Situation | Penalty |
|---|---|
| Shortfall not corrected | 25% of the amount not taken |
| Corrected within 2-year window | Reduced to 10% |
Example: $20,000 required, $15,000 taken, $5,000 shortfall x 25% = $1,250 penalty (or $500 if timely corrected).
Qualified Charitable Distributions
A Qualified Charitable Distribution (QCD) lets an IRA owner age 70 1/2 or older send up to $111,000 (2026) directly from the IRA to a qualified charity. The amount is excluded from gross income, can count toward the RMD, and cannot also be claimed as an itemized charitable deduction. Because it reduces AGI, a QCD helps even taxpayers who take the standard deduction.
Rollovers Between Plan Types
| From | To Traditional IRA | To Roth IRA | To employer plan |
|---|---|---|---|
| Traditional IRA | Yes | Yes (taxable) | If plan allows |
| Roth IRA | No | Yes | No |
| 401(k)/403(b) | Yes | Yes (taxable) | Yes |
| 457(b) | Yes | Yes (taxable) | Yes |
A Roth conversion moves Traditional money to a Roth: the converted amount is fully taxable in that year but carries no 10% penalty, and is often done in low-income years. Each conversion starts its own 5-year penalty clock.
Net Unrealized Appreciation
Net Unrealized Appreciation (NUA) is a strategy for employer stock held in a qualified plan. On a lump-sum distribution, the stock's cost basis is taxed as ordinary income immediately, but the appreciation (NUA) is taxed at favorable long-term capital gains rates when the shares are later sold.
Example: employer shares bought in the plan for $20,000 are now worth $100,000. The $20,000 basis is ordinary income at distribution; the $80,000 NUA is taxed as long-term capital gain (0-20%) when sold — far cheaper than rolling the stock to an IRA, where every dollar would later be ordinary income up to 37%.
Lump-Sum vs. Periodic Distributions and Withholding
Retirees generally choose between a lump-sum distribution (the entire balance at once) and periodic payments (annuitized or installment payouts). A lump sum gives control and enables strategies like NUA or a rollover, but a large taxable lump sum can spike the retiree into a higher bracket in a single year. Periodic payments spread the income — and the tax — over time. Plan distributions paid directly to the participant carry 20% mandatory withholding, while IRA distributions default to 10% withholding that the owner may waive. Roth qualified distributions are not subject to withholding because they are tax-free.
Inherited Accounts and the 10-Year Rule
Distribution rules change at the owner's death. Under the SECURE Act, most non-spouse beneficiaries must fully distribute an inherited IRA or employer plan within 10 years; eligible designated beneficiaries (a surviving spouse, a minor child of the owner, a disabled or chronically ill person, or a beneficiary not more than 10 years younger than the owner) may still stretch distributions over life expectancy. A surviving spouse may roll the account into their own IRA and restart RMDs under their own age.
Inherited Traditional balances remain ordinary income to the heir; inherited Roth balances are generally tax-free, though the 10-year payout still applies.
Common Distribution Traps Tested
| Trap | Correct rule |
|---|---|
| "Education exception applies to my 401(k)" | Education and first-home exceptions are IRA-only |
| "Roth IRAs require RMDs at 73" | No RMDs for the Roth owner during life |
| "Converting to Roth triggers the 10% penalty" | Conversions are taxable but not penalized |
| "Rolling employer stock to an IRA is best" | A direct IRA rollover forfeits NUA capital-gains treatment |
| "QCDs require waiting until 73" | QCDs begin at age 70 1/2 |
Master these five and you will capture the bulk of the distribution questions on the Series 7.
A 45-year-old takes a $30,000 distribution from her 401(k) to pay her daughter's college tuition. What are the tax consequences?
An individual turns 73 in 2026. By what date must the first required minimum distribution be taken?
What is the penalty for failing to take the full required minimum distribution from a Traditional IRA?
A 58-year-old separates from her employer and wants penalty-free access to her 401(k). Which circumstance lets her avoid the 10% penalty?
A 72-year-old directs $50,000 from her Traditional IRA straight to a qualified charity. Which statement about this Qualified Charitable Distribution is TRUE?