By Andy Ives, CFP®, AIF®
When it comes to taxes and the 10% early distribution penalty, do not allow the underlying investments within a Traditional IRA to confuse what is applicable. Earnings within an IRA are just earnings. It does not matter if those earnings come from appreciation, capital gains, dividends, rents, annuity income, interest, or really any other form of growth. If it happens within the IRA, it is essentially just “earnings.”
As such, if those earnings are withdrawn, regardless of the type of earnings, they will all be taxed the same – as ordinary income. And if those earnings are withdrawn before the age of 59 ½ – assuming no exception applies – they will also get hit with a 10% penalty. (Technically, the 10% penalty is referred to an “additional tax,” but a punch in the nose is a punch in the nose, whether it was a right fist or a left.) There is no special type of earnings within an IRA that can avoid taxes or the 10% penalty if withdrawn early – again, assuming no exception applies.
If a person under the age of 59 ½ has an annuity in his IRA, and if that annuity kicks off income, that income will not bypass the 10% penalty if withdrawn. If it is paid out to the IRA owner, it is a distribution and will be subject to all the rules and regulations of any other early distribution. Simply because the under-59 ½-IRA owner says it is the earnings from his annuity is irrelevant. That payout will be taxed as ordinary income and will be subject to the 10% early withdrawal penalty.
Where could that income payment from the annuity have gone? To a cash account within the IRA where it could sit or be reinvested.
Same thing with real estate. You are more than welcome to own a rental property within your IRA. Commercial buildings, summer homes, apartment complexes – you name it. All can be held within an IRA. But what to do with the rental income? Can it be paid out to the IRA owner? Of course, but it will “change its character” from rental income to ordinary income upon distribution. And if you are under 59 ½, expect a 10% penalty if no other exception applies.
To avoid taxes and a possible penalty, where could that rental income have gone? You guessed it…to a cash account within the IRA where it could sit or be reinvested.
Same deal when a stock held in an IRA pays a dividend. Same deal when a mutual fund pays a capital gain. Same deal when a municipal bond is accidentally purchased within an IRA and pays what would otherwise be tax-free interest (if it had been properly positioned in a non-qualified account). IRAs are already tax-exempt. You can’t double up the tax exemption with a muni bond. “Tax-free” interest from a municipal bond held in an IRA would change its character and be treated as ordinary taxable income upon withdrawal from the IRA.
There is an unusual type of income within an IRA that can, in fact, be taxable even if it isn’t withdrawn. That is “unrelated business taxable income,” or UBTI. We will tackle that subject some other time. For now, recognize that earnings within a Traditional IRA are just that –earnings. When earnings are withdrawn, they are subject to ordinary income taxes. And, if under age 59 ½, there will also be a 10% early withdrawal penalty…if no exception applies.