What Are Distribution Payments and How Are They Taxed?

A distribution payment is a withdrawal of funds or assets from an entity such as a retirement plan, business, or trust. These payments can originate from years of savings, business profits, or investment earnings. While receiving a payment seems straightforward, the tax implications are complex. The tax treatment of a distribution varies significantly based on the source of the funds, the type of entity making the payment, and the recipient’s individual circumstances. The tax consequences can range from completely tax-free to being taxed at high ordinary income rates, and may even include additional penalties.

Distributions from Retirement Accounts

The tax treatment of withdrawals from retirement accounts is determined by whether the plan is traditional (pre-tax) or Roth (post-tax). For traditional IRAs, 401(k)s, and 403(b)s, contributions are made with pre-tax dollars, lowering your taxable income in the contribution year. When you withdraw funds from these accounts, the entire distribution is treated as ordinary income and taxed at your current federal and state income tax rates.

Roth IRAs and Roth 401(k)s are funded with post-tax dollars, so contributions do not provide an upfront tax deduction. The benefit is that qualified distributions from Roth accounts are entirely tax-free. For a distribution to be qualified, the account must be open for at least five years, and the withdrawal must be made after you reach age 59 ½, become disabled, or for a first-time home purchase.

If you take a distribution from a traditional IRA or 401(k) before reaching age 59 ½, the amount is subject to ordinary income tax plus an additional 10% penalty. The Internal Revenue Service (IRS) allows for several exceptions to this 10% penalty, including:

• Distributions made due to total and permanent disability.
• Withdrawals for higher education expenses for yourself or a dependent.
• Funds used to pay for health insurance premiums while unemployed.
• Withdrawals of up to $10,000 from an IRA for a first-time home purchase.

Even when an exception applies and the 10% penalty is waived, the distribution from a traditional account is still subject to ordinary income tax.

Distributions from Business Entities

Distributions from business entities depend on the business’s tax structure. For pass-through entities like S-Corporations, partnerships, and most Limited Liability Companies (LLCs), the business itself does not pay income tax. Instead, profits and losses are “passed through” to the owners and reported on their personal tax returns each year, regardless of whether cash is distributed.

When an owner of a pass-through entity receives a cash distribution, it is often non-taxable because the owner has already paid income tax on their share of the profits. The distribution is treated as a tax-free return of the owner’s investment, known as their “basis.” If a distribution exceeds the owner’s basis, the excess amount is taxed as a capital gain.

Distributions from C-Corporations are handled differently, as these corporations pay income tax at the corporate level. Payments of profits to shareholders, known as dividends, are taxed based on whether they are “qualified” or “non-qualified.” Qualified dividends are taxed at lower, long-term capital gains rates of 0%, 15%, or 20% in 2025, depending on the shareholder’s taxable income.

To be qualified, dividends must be paid by a U.S. or qualifying foreign corporation, and the shareholder must meet holding period requirements. This means holding the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Dividends that do not meet these criteria are non-qualified and are taxed at the shareholder’s higher ordinary income tax rates.

Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory annual withdrawals that individuals must take from most tax-deferred retirement accounts. These rules apply to Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, and 403(b)s. Roth accounts, including both Roth IRAs and Roth 401(k)s, do not require RMDs for the original account owner.

Following the SECURE 2.0 Act, the age to begin RMDs was raised to 73. An individual turning 73 must take their first RMD for that year by April 1 of the following year. For all subsequent years, the RMD must be taken by December 31. Delaying the first RMD until the April 1 deadline means taking two RMDs in the same calendar year, which could result in a higher tax liability.

The RMD amount is calculated annually based on two factors: the retirement account’s fair market value as of December 31 of the preceding year and a life expectancy factor from the IRS’s Uniform Lifetime Table. The account balance is divided by the factor corresponding to the owner’s age to determine the minimum amount that must be withdrawn.

Failing to take the full RMD by the deadline results in a penalty. The SECURE 2.0 Act set this penalty at 25% of the amount that was not withdrawn. If the mistake is corrected in a timely manner, generally within two years, the penalty may be reduced to 10%.

Tax Reporting for Distributions

When you receive a distribution, the payer is required to report it to you and the IRS on a specific tax form. You use these forms to report the income on your Form 1040 but do not typically file the forms themselves with your return.

For withdrawals from retirement plans like IRAs and 401(k)s, you will receive Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Box 1 of this form shows the gross distribution amount, while Box 2a indicates the portion that is taxable. Box 7 contains a distribution code that provides information about the withdrawal, such as whether it was a normal distribution or an early withdrawal. This information is reported on lines 4 or 5 of Form 1040.

Distributions from C-Corporations, or dividends, are reported on Form 1099-DIV, Dividends and Distributions. Box 1a shows total ordinary dividends, and Box 1b shows the portion of those dividends that are “qualified” and eligible for lower capital gains tax rates. This information is transferred to line 3 of Form 1040.

For owners of pass-through businesses like S-Corporations and partnerships, income is reported on a Schedule K-1. This form details the owner’s specific share of the business’s income, deductions, and credits for the year. The K-1 reports your share of the entity’s taxable income, not the amount of cash you actually received as a distribution. The income figures from the K-1 are reported on Schedule E of Form 1040.