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Taxes on profit-sharing distributions

George SaenzDear Tax Talk,
What are the tax considerations regarding a distribution of after-tax funds from a profit sharing/savings plan? I have some after-tax funds in my account that were put into the account many years ago, before the before-tax option was available. The account statement shows these after-tax funds in the amount of about $56,000, a relatively small amount compared to the total in the account. I'm assuming that I can take that exact amount from the account and not have to owe any taxes on it. Could you advise me on this matter?
-- Stan

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Dear Stan,
If you already paid tax on some of your pension plan assets, you're right to assume that you won't have to pay tax on that money when it comes out. Unfortunately though, out of every payment you receive from the plan you have to split it between recovering your cost and the part that is taxable.

How you go about recovering your basis depends if you're taking periodic payments or nonperiodic payments. Periodic payments are when you've reached your retirement age and begin to withdraw a fixed monthly income over a certain time period, such as your remaining life expectancy or that of yours and your spouse's. A nonperiodic payment is an occasional withdrawal of funds either before or after reaching the age that you have to take minimum withdrawals.

If you're taking periodic withdrawals, the Internal Revenue Service has a simplified method for figuring the cost to be recovered. It's called the simplified method and is discussed in IRS Publication 575, Pension and Annuity Income. Basically, you take your cost in the plan and divide it by the number of payments to be received. If you die before getting your full cost recovered your estate can claim a deduction on your final 1040.

If you receive a nonperiodic distribution before you start to make regular (periodic) withdrawals from your pension, then the amount you withdraw comes out in the proportion that is your cost to the total account balance. For example, if your cost is $56,000 and your account balance was $560,000, then 10 percent of your withdrawals would be recovery of your cost and tax-free.

If you already started making regular withdrawals and decide to make an additional withdrawal, you usually have to include the full amount in income and continue to recover your cost over your remaining periodic payments. However, there are three limited exceptions to this rule discussed in Publication 575 that you can refer to if applicable.

-- Posted: March 29, 2005





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