Some people are tempted to choose the path of least resistance. This is true in life generally, but especially true in that part of life that requires dealing with the IRS. When taking distributions from a retirement plan, the easiest option is simply to take the money, deposit it in your regular bank account and report the amount of the distribution as ordinary income on your tax return at tax time.
But if your retirement plan distribution is large, you ordinarily would not choose to pay tax on the entire amount unless you need the money immediately and don’t qualify for any special tax options.
Another reason you might have to use the ordinary income tax option is if you made a procedural error when attempting to use one of the other tax options, which left you no choice but to use the ordinary income tax option.
Who is eligible?
Anyone who receives a distribution from a retirement plan can choose to have the distribution taxed in this way.
Which distributions are eligible?
All distributions you receive from a retirement plan that are attributable to pretax contributions or to investment returns may be taxed at ordinary income tax rates. This is true whether the distribution represents only part of your account of the entire balance.
Advantages and disadvantages
The advantage of this tax option is that once the money comes out of the retirement plan and you pay the taxes owed, you have unrestricted use of the funds. The money that you withdraw is no longer subject to the term of the plan.
But that peace of mind is expensive. Paying tax at ordinary rates on the money in the same year you receive it is usually the least advantageous option – at least from a financial perspective. If your distribution is large, it could easily push you into a higher tax bracket. Its hardly cheery to think of starting your retirement by handing the government 40% or more of your nest egg.