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October 24, 2020
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Finance

Ken Weise
Taxable events in retirement accounts
October 16, 2020

What triggers a tax liability for an individual or a trust?

When you distribute, sell, or receive assets from a retirement account, taxes usually follow. It is true for individuals; it is true for trusts. These decisions represent taxable events. 

Many retirement accounts are tax-deferred, but not tax-exempt. So, at some point, a “day of reckoning” arrives for these accounts and taxes are due. The tax liability may differ greatly, depending on account ownership. 

 Trust income is now taxed much more than individual income. This is a result of the Tax Cuts and Jobs Act of 2017.

 As an example, in 2019, a trust could earn up to $2,650 in taxable income without federal taxes on its qualified dividends or capital gains. That threshold was almost 15 times higher ($39,375) for an individual. Factor in a $12,200 standard deduction in that same year and an individual could potentially have up to $51,575 in qualified dividends to manage their federal income tax liability.

Additionally, an individual has to have net investment income or modified adjusted gross income in excess of $200,000 per year to face the 3.8 percent net investment income tax (NIIT). Compare that with a trust: the threshold is just $12,750.

Using a trust involves a complex set of tax rules and regulations. Before moving forward with a trust, consider working with a professional who is familiar with the rules and regulations.

Say an investment in your retirement account is sold for a capital gain. If it has been held in your account for less than a year, that capital gain is short term; short-term capital gains are usually taxed at the same rate as earned income. If those shares have been in your account for more than a year, then long-term capital gains tax rates likely apply, which are either 0 or 15 percent for most individuals.

A trust also faces the possibility of capital gains tax in this situation whether it distributes the gain, or it doesn’t. Both trusts and individuals can use capital losses to offset capital gains.

Suppose you receive dividends in a retirement account. In an ordinary brokerage account, qualified dividends are taxable annually whether the money is distributed, reinvested, or left in cash. The threshold for taxation of qualified dividends is much lower for a trust than for an individual. Reinvested dividends in an Individual Retirement Account (IRA) are not taxed.

Regarding IRAs, it is important to note that distributions from traditional IRAs must generally begin once you reach age 72. The money distributed to you is taxed as ordinary income. When such distributions are taken before age 59½, they may be subject to a 10 percent federal income tax penalty, although the CARES Act allows some exceptions to the penalties for 2020. (You may continue to contribute to a Traditional IRA past age 70½ under the SECURE Act as long as you meet the earned-income requirement.)

How are taxable events in retirement accounts reported and when are taxes withheld? Each tax year, Form 1099s tell the story. The 1099-DIV tracks dividends, the 1099-INT displays interest income and the 1099-R shows distributions out of pensions, IRAs, retirement plan, and insurance contracts.7

Now to withholding. Distributions from employee retirement plans have taxes withheld unless a trustee-to-trustee transfer occurs (i.e., the invested assets go seamlessly from one retirement plan to another, with the individual or trust never taking possession of them). The withholding rate in such instances is 20 percent. An IRA owner can choose not to withhold tax from an IRA distribution; otherwise, the withholding rate is 10 percent. There is no withholding at all, of course, on investment income from a taxable brokerage account or capital gains and losses.

Keep in mind that this article is for informational purposes only and not a replacement for real-life advice. Also, tax rules are constantly changing, and there is no guarantee that the tax treatment of IRAs and other qualified retirement plans will remain the same in years ahead, for individual taxpayers or trusts.

 

Ken Weise, an LPL Financial Advisor, provided this article. He can be reached at 707-584-6690. Securities offered through LPL Financial. Member FINRA/SIPC. The opinions of this material are for information purposes only.