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

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]

Thus, Bill will be taxed on only $100 of the $600 distribution and remaining IRA account balance will be $1,800 ($2,000+$400 – $600).

Nondeductible contributions will not be excluded from gross income as investment in the contract where the taxpayer is unable to document the nontaxable basis through the filing of Form 8606, Nondeductible IRAs (Contributions, Distributions and Basis) for the year in which such nondeductible contributions were made and the year in which they were distributed ( Q 3699).⁵

An individual may recognize a loss on a traditional IRA, but only when all amounts have been distributed from all traditional IRAs and the total distributed is less than the individual’s unrecovered basis.⁶ The deduction for the loss was typically a miscellaneous itemized deduction (all of which were suspended for 2018-2025 by the 2017 tax reform legislation—the IRS has yet to issue guidance that would otherwise allow this loss deduction during this time period).⁷

Despite the pro-rata rule generally applicable to distributions from a traditional IRA, distributions after 2001 that are rolled over to a qualified plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan are treated as coming first from all non-after-tax contributions and earnings in all of the IRAs of the owner.⁸ Because after-tax contributions cannot be rolled over to eligible retirement plans other than another IRA ( Q 3996, Q 4004), this ordering rule effectively allows the owner to rollover the maximum amount permitted. Appropriate adjustments must be made in applying IRC Section 72 to other IRA distributions in the same taxable year and subsequent years.⁹

The fact that IRA funds were distributed by the financial institution’s receiver following insolvency proceedings did not change the nature of the distribution. The taxpayers were taxed on the distribution since a timely rollover was not made.¹⁰

Likewise, the transfer of IRA funds by a financial institution into a “trust account” was a taxable distribution to the taxpayer even though the taxpayer had intended to transfer the IRA funds to another IRA and had named the account a “trust IRA” because the money was transferred into the trust account.¹¹

In addition, a failed Roth IRA conversion that is not recharacterized is treated as a distribution from a traditional IRA and taxed accordingly (note that the typical Roth IRA recharacterization rules were eliminated for tax years beginning after 2017).¹²

Taxpayers who were defrauded of their account balances by their investment advisor, who convinced them to make IRA rollover investments that the advisor subsequently embezzled, were liable for taxes on the amount of assets stolen because the account holders failed to take the necessary steps required to properly set up IRA rollover accounts.¹³

Prior to 2018, special rules applied for qualified hurricane distributions, as follows: Unless a taxpayer elects otherwise, any amount of a qualified hurricane distribution required to be included in gross income shall be so included ratably over the three year taxable period beginning with such year.¹⁴ If a qualified hurricane distribution is an eligible rollover distribution ( Q 4004), it may be recontributed to an eligible rollover plan no later than three years from the day after such distribution was received ( Q 4012).¹⁵ See Q - Q for a discussion on the treatment of disaster distributions in later years.  In recent years, Congress and the IRS have offered similar treatment for disaster-related distributions, including coronavirus-related distributions.

Certain early distributions are subject to additional tax ( Q 3677). As to what constitutes a “deemed distribution” from a traditional IRA, see Q 3649. For the estate tax marital deduction implications of distributions from a traditional IRA, see Q 3713.