Taxation of Retirement Distributions

This final section brings everything together by examining how distributions from each account type are actually taxed. Two rules in particular (the pro-rata rule and net unrealized appreciation (NUA)) are high-value exam topics.

Tax Treatment by Account Type

Key principle: Money that went in pre-tax (or was never taxed) comes out taxed as ordinary income. Money that went in after-tax comes out tax-free (to the extent of the basis). Roth accounts offer the best of both: after-tax in, tax-free out (including earnings).

The Pro-Rata Rule (Traditional IRA)

If a traditional IRA contains both deductible and non-deductible contributions, each distribution is treated as a proportional mix of taxable and non-taxable amounts.

How It Works

• You cannot cherry-pick to withdraw only non-deductible (after-tax) contributions first
• The rule applies across ALL traditional IRA accounts in aggregate; the IRS treats every traditional IRA you own as one combined pool
• Each withdrawal is proportionally taxable and non-taxable based on the ratio of after-tax dollars to total IRA value

Example

If your combined traditional IRAs hold $100,000 total, and $20,000 came from non-deductible contributions:

• After-tax ratio: $20,000 / $100,000 = 20%
• Every distribution is 20% tax-free (return of basis) and 80% taxable (ordinary income)

Exam Tip: Gotchas

• You cannot cherry-pick after-tax money from a traditional IRA. The IRS treats all your traditional IRAs as one pool, so each withdrawal is proportionally taxable and non-taxable.
• The pro-rata rule aggregates all traditional IRAs, SEP-IRAs, and SIMPLE IRAs. You cannot isolate one account to avoid it.
• Backdoor Roth trap: if you have pre-tax IRA money, converting non-deductible contributions triggers pro-rata taxation.

Net Unrealized Appreciation (NUA)

NUA is a tax strategy that applies when employer stock is distributed from a qualified plan in a lump-sum distribution.

How NUA Works

1. Employee receives employer stock in kind (not sold) as part of a lump-sum distribution from a qualified plan
2. Only the cost basis of the stock is taxed as ordinary income at distribution
3. The NUA (appreciation that occurred while the stock was in the plan) is taxed at long-term capital gains rates when the stock is eventually sold
4. Any appreciation after distribution is taxed as short-term or long-term capital gains depending on holding period

Why It Matters

• The maximum long-term capital gains rate (20%) is significantly lower than the maximum ordinary income rate (37%)
• For highly appreciated employer stock, the NUA strategy can save substantial taxes compared to rolling the stock into an IRA (where all distributions would be ordinary income)

NUA Requirements

• Must be a lump-sum distribution (entire balance distributed in a single tax year)
• Must be triggered by a qualifying event: separation from service, reaching age 59-1/2, death, or disability
• The stock must be distributed in kind (transferred to a brokerage account, not sold within the plan)

Exam Tip: Gotchas

• NUA only applies to employer stock distributed in kind. If the stock is sold inside the plan and distributed as cash, NUA treatment is lost and the entire amount is ordinary income.
• NUA appreciation is always taxed at long-term capital gains rates, regardless of how soon you sell after distribution.

Taxation Summary by Scenario