 Hello and welcome to the session in which we would look at the taxation of traditional and Roth IRA distribution. So it's very important that you understand the nature of traditional and Roth IRA. Why? Because if you understand the nature of these two type of retirement accounts, then it's very easy to understand the distribution. If you'd like to go to the previous recording, I spoke about traditional and Roth IRA. Now this topic is covered on the CPA exam as well as the enrolled agent exam and in your income tax course. If you are a CPA candidate or an enrolled agent candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA or EA review course. I can be a useful addition. I can be a backup system. I can explain the material differently. And by doing so, I can help you understand the material and add 10 to 15 points to your exam. Keep your course. That's not my intent. Your risk is one month of subscription. You try it. You don't like it. You cancel. The reward is potentially passing your exam, passing your CPA and enrolled agents exam. If not for anything, take a look at my website to find out how well or not well your university doing for the CPA exam. This is a list of all the courses that I cover. Also connect with me on LinkedIn if you haven't done so. Like this recording. Subscribe to my YouTube channel. Share it with others. Connect with me on Instagram, Facebook, Twitter and Reddit as I'm trying to grow my Reddit following. So let's go back and review traditional versus Roth. Again, you need to know how traditional and how Roth work because when we make the distribution, if you know how it works, it's very easy to remember. Now, the distribution from an individual IRA, it's going to be fully taxable. So it's easy if the IRA, if the plan was funded with deductible contribution. So if you did not pay taxes, so when you made the contribution, you made it with pre-tax. Guess what? The government says, now it's the time to tax you. Now it's the time to tax you. They will tax you now and they will tax you on the amount that you contributed and they will tax you on the earnings that you earned in this account. If it was funded with deductible and not deductible amount. So what you contributed, some of the money was already taxable and some of it was not taxable. Some of it you were able to deduct and some of it was not deductible. Then guess what? In this situation, it's going to be partially taxable. So some of the distribution will be taxable and some of it will not be. So this is what we need to learn. This is where the complexity comes because in situation one, when the amount is fully deductible, the full amount is taxable. It's easy. So when it's not, then you have to determine first the tax basis for the IRA. And what is the tax basis? When we say the tax, what's your basis in the IRA? The basis is the money that you deducted that was non-deductible. Non-deductible means you already paid taxes on it. You were not able to deduct. So that's your basis in the IRA. This is your basis. And remember, you don't pay your taxes twice. If you already paid taxes, when you take this money out, you don't have to worry about it. So the tax basis equal to the sum of all non-deductible contribution made to the IRA minus the sum of all non-taxable distribution received as of the beginning of the year. So your basis will go down from year to year because as you're using it, it's going to go down. And simply put, what you have to do is you have to figure out a ratio. What is your ratio? And this is the ratio. We're going to talk about this ratio in a moment. What is your ratio of the basis? How do you find out the ratio? Your tax basis in the IRA. What's your tax basis? And year after year, this tax basis will go down because as you are receiving contribution, part of it will be the basis. Your tax basis divided by the end of the year asset value plus the distribution. So you're going to find a ratio and this ratio, it's going to be the amount, the ratio of the non-taxable distribution. You're going to take this ratio multiplied by the distribution. That's what you have to do. Well, the best way to illustrate this is obviously working an actual example. John, age 65, retired in 2020. During the year, he received $7,000 from his IRA. So the question is, what's the $7,000? Is it fully taxable, not taxable? Here we go. The easy answer is this. If John funded all his IRA with deductible money, with money that he did not avoid the taxes, then the full amount is taxable. It will be an easy answer. But John made non-deductible contribution of $10,000 to his IRA in the prior years and never received a non-taxable distribution. So his basis today is $10,000. The value of the IRA is $100,000. Now we have to use the formula that I showed you earlier. And this is the ratio right here. We're going to take the basis, which is $10,000, which are the non-deductible distribution, divide this by the value at the end of the year, $100,000 plus the distribution. So if we take $10,000 divided by $107,000, it's going to give us approximately around 9%. Let's do this calculation real quick. So we're looking at $10,000 divided by $107,000. And the ratio is 9.345. So the ratio is 9.345. And what we're going to do, we're going to take this rate, you know, 9.345%. We're going to take this multiplied by $7,000. And the amount that's non-taxable from the $7,000 is $6.54. What does that mean? It means the remainder is taxable. So the remainder is taxable. And the remainder is $6,346. But remember now what happened to John's basis? John's basis went down going forward because his basis was $10,000. He got back $6.54 in 2020. Therefore, his basis in the future years, what we'll use in the numerator, will be this number here. And year after year, his basis will go down. So this is how it works for a traditional IRA. For a Roth IRA, remember for a Roth IRA, it's simpler. There's no minimum withdrawal from a Roth IRA. If you meet the five-year holding period, it's even easier. You don't have to worry about anything. None of it is deductible. And remember, Roth IRA, you finance it with already taxed money. So when you take out withdrawals from Roth, you would assume it's coming from the contribution. So first it's ROC, return of capital. Then it's coming from earning if you happen to withdraw and there's any tax consequences. So withdrawing any money within five-year window are not taxable to the extent that they do not exceed the contribution. So let's assume you did not wait for five years and you started to take the money out. The assumption is you're taking your principal out first. Once that principal is depleted, let's assume you contributed $8,000 in total to your account. And it earned $4,000. So you have total of $12,000 in the account. So if you take any money out within that five-year period, it means you did not wait. The assumption is it's coming out of this amount first, return of capital, which is your principal, which is not taxable. And this, as we said, this is the earnings, $4,000. Let's work a quick example. Jerry and Tom established and funded the Roth IRA in 2016 and they made an annual contribution of $2,000 every year since then. If other distribution requirements are met, Jerry and Tom can make tax-free withdrawal from their IRA starting 2021. So starting 2021 going forward, once they take and they meet all the requirement, anything they take from the Roth IRA, it's tax-free. Let's assume they made withdrawal in 2020, which is before they meet the requirement. Simply put, because they contributed $10,000 2016, 17, 18, 19, and 20, we're going to assume they made their contribution in 2020. So they have a principal or a capital like a basis of 10, quote, basis of $10,000. So what happened is they can take up to $10,000 out before any tax consequences hits. Okay, but they're going to lose on the earnings because now they violated the requirements. They did not hold for five years. But what I'm trying to say is if you take the money earlier prematurely, it's considered coming from principal first, which is good. That's really good. You don't get hit with the taxes. At the end of this recording, I would like to remind you that if you are a CPA candidate or an EA candidate to check out my website, farhatlectures.com, I present the information differently. I give you resources. I can be a useful addition. That's all I can promise you. I can promise you to explain the material differently. And it might help you stay safe. Good luck and study hard for your CPA exam.