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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121114  
Subject: Re: Tax issues during early withdrawal from Roth Date: 12/4/1998 7:08 PM
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[[Hello,]]

Hi there...

[[ I had posted this message in a different folder but realized that this is a better place to post.]]

Well, you might want to go back to the original folder and tell 'em that you've moved the question. No use having another Fool rackin' their brain for an answer that you'll get here.

[[ I have a couple of questions regarding early withdrawal (before age 59.5 and with no hardship
etc)from a roth ira account. ]]

Ok...I'll see if I can give you a couple of answers.

[[(Ofcourse, I understand it is not a good idea to withdraw early etc).]]

Of course...

[[ I am planning to move $8000 from my previous employer's 401K to a roth.]]

Remember that you'll have to go to a regular IRA first, and then to a Roth IRA. Just a little technical issue that I don't want you to overlook.

[[ I also plan to add
$2000 this year for a total of $10000. So my initial investment will be $10000 and I plan not to
add any more money into the account.]]

But, again, in technical terms, what you really have is a $2k contribution and an $8k conversion. The rules treat them differently, which is why it is important to make sure that they are identified correctly.

[[ In 10 years if this amount grows to, say $30000, can
someone let me know the tax and penalties that I will pay at the end of 10 years if-
1. I withdraw $5000, which is less than what I initially invested.]]

Due to the IRS ordering rules, the first $2k of the contribution would be a return of your original $2k contribution. Not subject to tax or penalty. The next $3k would be considered part of your converted IRA. It would be subject to tax (at your marginal tax rate), but would NOT be subject to penalty, since you retained it in the Roth IRA for more than the required five tax year period.

[[ 2. I withdraw $15000, which is greater than what I initially invested.]]

Again, because of the ordering rules, the first $2k would be a return of your initial contribution...not subject to tax or penalty. The next $8k would be distributed from the original conversion, and would be subject to tax, but NOT penalty (again, because it was held for longer than the required five tax year period). Finally, the remaining $5k would be considered as distributed from the earnings of the Roth IRA. It would be subject to both taxes and the 10% penalty.

[[ Also, is there a limit on the number of early withdrawals that I may make from a Roth/regular ira?]]

Nope. As long as you can stand the tax and penalty hit, the IRS will give you all of the rope you need to hang yourself.

[[ Assume a 20% tax bracket at the time withdrawal.]]

Simply multiply the "taxable" amounts identified above by your marginal tax rate. If you would like to assume 20%, then use that number.

[[ I recall seeing a 4 part article about roth ira sometime this year. Could someone direct me to that?]]

It's gone. It was in the Taxes FAQ area. But it is being re-written and the first installment should already be up, with the remaining installments to follow in the next few weeks. So check it out in the Taxes FAQ area.

But since you have been so nice, I'll give you a sneek preview of Part IV...the part that you are mainly concerned about...

Roth IRA Redux - Part IV

After discussing contributions, conversions, and distributions, we'll now look at the penalty issues regarding "early" distributions from a Roth IRA.

Penalties on Earnings from Contributions

Unless an exception applies, any distribution from a Roth IRA before an individual reaches age 59 ½ will be subject to an "early withdrawal penalty" in the amount of 10% of the amount of the distribution required to be included in your gross income. Be very careful NOT to confuse the early withdrawal penalty with the taxes imposed on a non-qualified distribution (discussed in Part III): A non-qualified distribution imposes a tax on the distribution, but the early withdrawal penalty will be imposed in addition to the tax.

Example: Jim, age 30, makes a Roth IRA contribution of $2,000 in 1998. In year 2005, Jim's Roth IRA has a balance of $3,500. Jim decides to close his Roth IRA in a non-qualified distribution in year 2005. Since the distribution is non-qualified, Jim will owe taxes on his Roth earnings of $1,500, and will pay tax on this amount at his marginal tax rate. In addition, since the distribution took place before Jim reached age 59 ½, and since Jim did not meet any of the exceptions, Jim will also be assessed a 10% early withdrawal penalty on the earnings. If we assume that Jim is in the 28% marginal tax bracket, he will pay $420 in tax on the earnings, and will pay a penalty in the amount of $150 on the early distribution. This could be a very steep price to pay.

Exceptions

The 10% early withdrawal penalty does NOT apply to the following distributions:

1. to a beneficiary because of the death of the Roth IRA owner
2. due to the disability of the Roth IRA (disability as defined by IRS Code Section 72(m)(7)
3. that are part of a series of substantially equal periodic payments made at least annually for the life (or life expectancy) of the Roth IRA owner or the joint life (or expectancies) of the Roth IRA owner and the beneficiary
4. to the extent that the distributions do not exceed the amount allowable as an itemized medical deduction (regardless of whether you itemize your deductions or not)
5. to unemployed individuals for the purchase of health insurance premiums
6. to pay higher education expenses
7. to pay for qualified first-time homebuyer expenses
8. for distributions after December 31, 1999 to pay a levy under Code Section 6331 on the IRA

As you will note, these are similar to the penalty exceptions that apply to a regular IRA. For an additional discussion on these penalty exceptions, read IRS Publication 590 at the IRS web site (http://www.irs.ustreas.gov).

Penalties on Conversions from a Regular IRA to a Roth IRA

The penalty rules regarding rollovers are a bit different from contributions. Remember that with contributions, you can withdraw your "principal" contribution at any time, and that principal withdrawal will not be subject to taxes or penalties (as noted in the example for Jim above, and as discussed in the Roth IRA Part III post).

But an early withdrawal of a prior conversion has a different twist. The early withdrawal penalty applies to a distribution from a Roth IRA of a prior conversion but:

1. Only if the distribution is made within the five-tax year period starting with the year that the conversion was distributed from a regular IRA; and

2. Only to the extent that the distribution is attributable to amounts that were includible in gross income as a result of the conversion.

Example #1: Paul makes a $20,000 conversion from his regular IRA to a Roth IRA in 1998. The entire amount converted is includable in Paul's income for 1998 (let's assume that Paul didn't take the 4-year spread option…but the penalty would be the same even if he did). Paul makes no additional contributions or conversions in later years. In 2001, before he is age 59 ½, Paul withdraws $10,000 from the Roth IRA. While Paul will have no tax to pay on this withdrawal, he WILL have to pay a 10% penalty (or $1,000) unless one of the exceptions apply. Why? Because Paul didn't keep the conversion amount in his Roth IRA for the required five-tax year period, and this amount was required to be reported as income when Paul made his original conversion.

So if you are going to take funds "early" from your Roth IRA, weigh your conversion decision very carefully…especially if you made non-deductible contributions to your original IRA. If you made non-deductible contributions to your regular IRA, you'll be worse off my converting to a Roth IRA and taking the funds early than you would by simply taking the funds from the regular IRA. Why? Because a pro rata part of all withdrawals from a regular IRA are treated as coming out of non-deductible contributions. But amounts withdrawn from conversions to a Roth IRA are treated as coming out of income taken into account on the conversion first. But we'll talk about that in more detail when we discuss the "ordering rules".

But, on the other hand, if you are reasonably young (somebody under age 50), and expect to need to withdraw funds from an IRA in five years (and can't use any exceptions to avoid the 10% penalty) you may be better off converting over funds in your regular IRA to a Roth IRA now. Why? If the rollover amount isn't withdrawn until AFTER the five-tax year period, the 10% penalty won't be imposed, even if the withdrawal from the Roth IRA occurs before you turn age 59 ½ and no other exception to the penalty applies. Why? Because for a Roth IRA you have met the five-tax year exception, and therefore dodge the 10% penalty. But there is NO five-tax year exception for a regular IRA. So while you would still pay tax on the earnings in either case, you would dodge the 10% penalty by converting to a Roth IRA.

As you can see, the tax planning implications are numerous…too numerous to mention here. Just be careful when making your Roth IRA decisions.

Income Acceleration

But how do you deal with the income and penalty issues if you DO decide to spread your conversion income over a four-year period, and decide to remove those funds early from your Roth IRA? You'll get hit with income acceleration. Here's how it works.

The law says that if you withdraw converted amounts in any tax year BEFORE the last year of the four-year spread you'll have to include in income any amounts withdrawn, which have not yet been subject to tax. The rules are a lot more technical than this simple sentence, but hopefully the following example will give you the theory behind the law.

Example #2: Jill has a regular IRA with a value of $40,000, consisting of $10,000 in non-deductible contributions and $30,000 or earnings. Jill converts this regular IRA to a Roth IRA in 1998, and decides to use the four-year income spread. Jill will be required to report $7,500 in income for each of the four years beginning with 1998 ($30,000 earnings divided by 4 = $7,500). In early 1999 Jill makes a withdrawal of $10,000. In 1999, Jill will have to include $17,500 in her gross income. This $17,500 amount consists of the $7,500 normally required to be reported in 1999 (because of the four-year income spread) plus the $10,000 withdrawal. In year 2000, Jill will be required to include $5,000 in her gross income, since that is all that is left of the original four-year spread amount ($7,500 reported in 1998, $17,500 reported in 1999, with $5,000 to be reported in 2000…which all amounts to the initial $30,000 on which tax was due). In year 2001 (the fourth year under the four-year spread), Jill will NOT be required to include any additional amounts in her gross income, since the taxable amounts were previously reported and taxed because of the early withdrawal. And, with respect to penalties, Jill would pay an additional $1,000 in penalties on her $10,000 distribution that was taken in 1999, assuming that she doesn't qualify for any of the exceptions to the penalty.

So, if you decide that you will beat Uncle Sammy by taking the four-year income spread, and then taking a distribution early in 1999, you can just forget about it. It just doesn't work.

IRS Ordering Rules

But what if you have a more complicated situation, where you have contributions, conversions, and earnings all mixed up in the same account? And you decide to take a distribution? What are you really taking? Well, IRS has deemed that Roth IRA distributions MUST be withdrawn in the following order:

(*) First from non-taxable contributions to the Roth IRA (other than conversion amounts)
(*) Second from conversion contributions, on a first-in first-out (FIFO) basis
(*) Third from earnings

Who cares? You might…especially if you find that you have to take an early withdrawal. Let's look at another example:

Example #3: Roy converts $80,000 from a regular IRA to a Roth IRA in 1998. Of the amount converted, $20,000 represents non-deductible contributions and $60,000 represents earnings. Roy decides to spread his taxable income attributable to this conversion over the four-year period, and will include $15,000 in income for the next four years, beginning with 1998. In 1998 he also makes an annual contribution to the Roth IRA in the amount of $2,000. In 1999, when the value of the Roth IRA is $82,000 ($70,000 converted, $10,000 in earnings on the converted funds, and $2,000 in contributions). At that time, Roy takes a $25,000 withdrawal from the Roth IRA account.

Of the amount withdrawn, $2,000 is treated as a tax-free (and penalty free) withdrawal of the $2,000 contribution he made in 1998. The next $23,000 is treated as coming from the converted funds.

In 1999, he must include $38,000 in his gross income. Why? Because of the income acceleration rules. This would include the $15,000 required from the normal income spread, and the $23,000 taxable withdrawal itself. In year 2000 he would report $7,000 as the remaining taxable portion of the original $60,000 income spread, and in year 2001 he would not be required to report any additional income under the four-year spread rules (since these amounts were accounted for in previous years).

With respect to penalties, Roy would get hit with a penalty of $2,300 (10% of the taxable withdrawal) in 1999.

So there you have it. The moral to the story: Keep your hands off of your Roth IRA funds. But, seriously, you can certainly see how complicated the reporting can become. So unless you are able to do a LOT of reading on the Roth IRA distribution rules, you might just want to leave the account alone.

Next week we'll close with some final Roth IRA thoughts.

Hope this helps...
TMF Taxes
Roy

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