3671 / How are amounts distributed from a traditional IRA taxed?

Distributions from a traditional IRA generally are taxed under IRC Section 72 (relating to the taxation of annuities).¹ Under these rules, a portion of the distribution may be excludable from income. The amount excludable from the taxpayer’s income in a given year is that portion of the distribution that bears the same ratio to the amount received as the taxpayer’s investment in the contract (i.e., nondeductible contributions) bears to the expected return under the contract. In no case will the total amount excluded exceed the unrecovered investment in the contract.²

All traditional IRAs are treated as one contract, all distributions during the year are treated as one distribution, and the value of the contract, income on the contract, and investment in the contract are computed as of the close of the calendar year with or within which the taxable year begins.³ Thus, the nontaxable portion of a distribution (whether from a traditional individual retirement annuity or account) is equal to the following:

Unrecovered Nondeductible Contributions	× Distribution Amount
Total IRA Account Balance + Distribution amount + Outstanding Rollovers

The total IRA account balance is the balance in all traditional IRAs owned by the taxpayer, as of December 31 of the year of the distribution. The amount of any distributions made (i.e., the amounts for which the nontaxable portion is being computed) and any outstanding rollover amounts (i.e., any amount distributed by a traditional IRA within 60 days of the end of the year, which has not yet been rolled over into another plan, but which is rolled over in the following year) are added to the total IRA account balance. If it is not rolled over, the amount is not treated as an outstanding rollover.⁴

Example: Bill King has made nondeductible contributions to a traditional IRA totaling $2,000, giving him a basis at the end of 2024 of $2,000. By the end of 2025, his IRA earns $400 in interest income. In that year, Bill receives a distribution of $600. Of the $600 received by Bill, the nontaxable portion of the distribution is equal to $500, calculated as follows:

$2,000 [total unrecovered nondeductible contributions]	× $600 [distribution amount]
$2,400 [total IRA account balance + distribution]