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TMFPixy,

I appreciate your response to my question posed on 9-27-98 (?) regarding contribution limits for a SIMPLE IRA and Roth IRAs for 1998.

<...In this case, you will also have to close both Roth IRAs. In the latter, you won't be penalized on the excess contribution, but you will have to pay taxes and an early withdrawal penalty of 10% on any earnings generated from the original
deposits.>

I couldn't find the logic in having to pay a 10% penalty on any potential gain if we withdrew our excess contribution within the proper amount of time. So, I delved into the matter further on my own and thought I should share the information.

At the IRS website I downloaded Publication 553. In Chapter 3, 1998 Changes, Roth IRA, the IRS says that excess contributions can be "withdrawn penalty free if they are withdrawn on or before the due date (including extensions) for filing a tax return for the year." However, under the section of the publication that deals with Education IRAs it said, "The 10% additional tax also does not apply to a distribution that is a return of an excess contribution. For the additional tax not to apply, the distribution must be made before the due date of the contributor's return (including extensions) and it must include any net income attributable to that contribution. That net income also must be included in the contributor's gross income for the tax year the contribution was made."

To verify that the above quote applied to Roth IRAs other than Education Roth IRAs, I called the IRS. I was told that the 10% penalty would not apply to us, whether or not our Roth's were education Roth's. I was told that in Publication 590 on page 14, there is a section applying to tax free withdrawal of excess contributions to IRA's. (I haven't looked this up, however.) The man I spoke to said that rules for Roths are the same as for traditional IRAs concerning premature withdrawals and that the 10% penalty in question does not apply as long as we withdraw both the excess contribution as well as any income generated from them by the proper time.

Now I have an even more complicated additional question. The money ($2,000.00 each) that my husband and I each contributed to our Roths in early 1998 that we will need to withdraw before, say, April 15th of 1999, was invested in two Foolish Four stocks on February 4th, 1998. The IRS man told me that any "gain" that those stocks had on the date we might transfer those stocks to our joint (taxable) securities account (assuming we do so before filing our 1998 tax return) would be treated as ordinary income for 1998. At the moment, we have a gain on one of them and a loss on the other. I have never heard of a "loss" to ordinary income and don't even know how one reports it on a tax return! I don't understand why any "gain" shouldn't be taxed at the 20% rate if we were to wait until February 5th. In your opinion, would we be better off if we wait until February 5th of 1999 to sell or transfer to our taxable securities account (if one or both are still on the Fool 4 list) these 2 stocks of our Fool 4, or to take care of the transfer of stock to our "taxable" brokerage account now? I appreciate any insight you may have.

Thanks,

Boardhead
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Boardhead, you wrote:

I appreciate your response to my question posed on 9-27-98 (?) regarding contribution limits for a SIMPLE IRA and Roth IRAs for 1998.

<...In this case, you will also have to close both Roth IRAs. In the latter, you won't be penalized on the excess contribution, but you will have to pay taxes and an early withdrawal penalty of 10% on any earnings generated from the original
deposits.>

I couldn't find the logic in having to pay a 10% penalty on any potential gain if we withdrew our excess contribution within the proper amount of time. So, I delved into the matter further on my own and thought I should share the information.

At the IRS website I downloaded Publication 553. In Chapter 3, 1998 Changes, Roth IRA, the IRS says that excess contributions can be "withdrawn penalty free if they are withdrawn on or before the due date (including extensions) for filing a tax return for the year." However, under the section of the publication that deals with Education IRAs it said, "The 10% additional tax also does not apply to a distribution that is a return of an excess contribution. For the additional tax not to apply, the distribution must be made before the due date of the contributor's return (including extensions) and it must include any net income attributable to that contribution. That net income also must be included in the contributor's gross income for the tax year the contribution was made."


A Roth IRA is just like a traditional IRA when it comes to distributions. In that, the IRS advised you correctly. What they didn't say, was on page 34, IRS Pub 590, they also say "Your withdrawal of interest or other income may be subject to an additional 10% tax on early withdrawals, discussed later." The "later" discussion concerns distributions prior to age 59 1/2 that fail to meet one of the exceptions, and withdrawal of excess contributions is not one of the exceptions. Removal of your excess contributions and earnings thereon by the due date of your return will avoid the excess contribution penalty of 6%. You must also declare the earnings as income for the year of the contribution (i.e., 1998) even if taken in a subsequent tax year (i.e., 1999). BUT ---- You may NOT avoid the 10% early withdrawal penalty on those earnings unless you meet one of the exceptions for an early withdrawal specified under Section 72(t) of the tax code. That's because the withdrawal IS a distribution (even if the contribution shouldn't have been there), and is also NOT a qualified distribution from the Roth. Therefore, unless you and your husband are older than age 59 1/2, just as in a traditional IRA you will be hit with a 10% penalty on any earnings taken on the withdrawal.

To verify that the above quote applied to Roth IRAs other than Education Roth IRAs, I called the IRS.

I hope they told you there's no such thing as an "Education Roth IRA" because there is no such animal. There's an Education IRA (a very bad name) and there's a Roth IRA. For an explanation of both, see my Foolish Retirement Plan Primer at http://www.fool.com/retirement .

Now I have an even more complicated additional question. The money ($2,000.00 each) that my husband and I each contributed to our Roths in early 1998 that we will need to withdraw before, say, April 15th of 1999, was invested in two Foolish Four stocks on February 4th, 1998. The IRS man told me that any "gain" that those stocks had on the date we might transfer those stocks to our joint (taxable) securities account (assuming we do so before filing our 1998 tax return) would be treated as ordinary income for 1998. At the moment, we have a gain on one of them and a loss on the other. I have never heard of a "loss" to ordinary income and don't even know how one reports it on a tax return! I don't understand why any "gain" shouldn't be taxed at the 20% rate if we were to wait until February 5th. In your opinion, would we be better off if we wait until February 5th of 1999 to sell or transfer to our taxable securities account (if one or both are still on the Fool 4 list) these 2 stocks of our Fool 4, or to take care of the transfer of stock to our "taxable" brokerage account now?

In an IRA there is no recognition of capital gains. If you have earnings and withdraw them, they will be taxed as ordinary income. That you won't be able to avoid in this case. That's true even if you wait until April 15, 1999, to remove the excess deposit. In one account, then, you'll have gains reportable as ordinary income (and subject to the premature withdrawal penalty of 10%). In the other, you have a loss on the original basis of $2K. Page 28, IRS Pub 590 says: "If you have a loss on your IRA investment, you can recognize the loss on your income tax return, but only when all the amounts in your IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2% limit, on Schedule A, Form 1040." Therefore, if that loss exceeds 2% of your AGI for the year, you'll get an offsetting deduction to the income.

I don't know your tax situation, nor am I a tax expert by a long shot. Therefore, I'm not sure how you want to handle this: Remove all now or by April 15. And to just add a wrinkle, you have another option. You can just leave the money there, pay the 6% (or $240) penalty, and on January 1, 1999, call them your 1999 Roth IRA contribution. That way you don't have to worry about the income or the loss because you don't have to take anything out. But only you in conjunction with your tax advisor can determine what's the best course of action for you.

Regards….Pixy
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