Legal Blog

The Weekly Scenario: Differences in SEP, Simple IRA and a Traditional IRA

Question: Is there any difference in the taxation of distributions between a SEP, Simple IRA and a so-called traditional IRA?

Answer: There is no difference between your SEP, Simple and traditional IRA in terms of taxation of distributions. If you made a non-deductible contribution to a traditional IRA and also have SEP IRA funds in another account, any distribution from the SEP IRA will consist of a portion of the after-tax funds that were contributed to the traditional IRA. Most practitioners refer to this as the pro-rata rule which means that these accounts (SEP, SIMPLE and Traditional) are viewed as one large account. Then the tax free portion of a distribution is calculated by comparing the total after tax value in all (non-Roth) your IRAs to the total value in all of your (non-Roth) IRAs. So, in a simple example, say your SEP and SIMPLE IRAs consist solely of pre-tax funds worth $30,000 and $20,000 (respectively) and your traditional IRA consists of $10,000 after tax and $40,000 pre-tax funds. The total value of all your IRAs is $100,000 — $10,000 represent after-tax contributions. $10,000/$100,000 or 10% of your IRA consists of after-tax funds. As such, 10% of any distribution you take from any one of your non-Roth IRAs will consist of after-tax funds, regardless of which IRA you take the distribution. The balance of the distribution would be taxable. If you decided to take the distribution from the SEP, the tax treatment would have been exactly the same. Comment: Most early distribution penalties for taking funds out before age 59 ½ is 10%. In doing my research for this question one thing I learned is that for SIMPLE IRAs, the pre-age 59 ½ distributions are subject to a penalty of 25% and not the more common 10% early distribution penalty. If you have any questions or would like more information please contact Steve Shane at:sshane@offitkurman.com | 301.575.0313.

ABOUT STEVE SHANE

Steve Shane Head Shot for webSteve Shane provides strategic counseling to clients in need of estate administration, charitable giving and business continuity planning while minimizing estate, gift, and generation-skipping transfer tax exposure. He offers legal guidance to clients on asset protection and the proper disposition of assets in accordance with the client’s objectives, while employing tax planning techniques such as the use of irrevocable trusts, life insurance planning, lifetime gifts and charitable trust. He is also experienced with drafting documents for business planning, the incorporation and application for exemption for Private Foundations and the administration of decedents’ estates.

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