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Folks, the situation is as follows:

taxpayer loses job in 2004 and starts own business. Business is not making any money and taxpayer has incurred huge debts to get it going. He has small amount in rollover IRA (maybe 1/4 of the debts). He understands that a 10% penalty would apply to any amount withdrawn to pay off some of the debt. What I would like to know is whether the withdrawal is taxed at the taxpayer's ordinary income rate for the year of the withdrawal (plus the 10%) or some different rate? Also, assuming no other income, is there a point where the amount of the withdrawal affects the tax rate (i.e. are there "extra" penalties for taking out 50k instead of 25k in the form of higher tax rate)? thanks.
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Principal put into a Roth can be taken out tax and penalty free, only gains are a problem. Roths are post tax, so I believe any gain distribution would just have the 10% penalty and not taxed. For the same reason, distributions would not put you into a higher tax bracket.

However, I would suggest you look at any and ALL other options before screwing with your retirement plans. People who make loans to startup businesses do so with the expectation that many of them will fail and they will not receive their principal back. I do not know the details of the law, but I recommend you get legal advice and consider bankrupcy (of yourself or your business, if separate) and consider how much of the debt can be written off. I know the recent bill (yay for lobbyist!) makes that harder, but you owe it to yourself to consider all options.

If the bank loses some of their funds, big whoop, it was a calculated risk. If you lose your retirement funds, that could alter your life permanently.
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Thank you, but this is not a roth IRA; just a rollover from a 401k.
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Ugh.

Can the taxpayer declare bankruptcy? Such would preserve the IRA.

The withdrawal from the IRA is added to your ordinary income.

If this pushes you into a higher bracket, the amount of income above the bracket level is taxed at the higher bracket rate.

The bracket levels depend on your filing status. I'll assume "single" since you didn't mention any family for our taxpayer.
The brackets currently are:
10% up to $7,300
then 15% up to $29,700
then 25% up to $71,950
then 28% up to $150,150
then 33% up to $326,450
then 35% on rest of income

Situation 1
Say you have $10,000 in your rollover IRA. You withdraw, 20% is withheld. You get $8000 (the $2000 goes straight to the IRS). When you go to settle your taxes, you owe $1000 penalty; your standard deduction ($4850) and personal exemption ($3100) reduce your taxable income to $2050 so your total tax is $1205. You get a $795 refund.

Situation 2
Say you have $100,000 in your rollover IRA. You withdraw, 20% is withheld. You get $80,000; $20,000 goes to the IRS. When you go to settle your taxes, your taxable income starts at $100,000; your standard deduction and personal exemption reduce your taxable income to $92,050. you find your total tax is $10,000 + $20,281 = $30,281. You owe $10,281 -- way too much -- so you get hit with underpayment penalties. If you want to avoid this situation you make estimated quarterly payments during the year.
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DeltaOne81,

Distributions of earnings from a Roth are only tax free under very specific circumstances. Early withdrawals have to satisfy very tight conditions to be tax-free (and the conditions are tighter if the money was due to a conversion). This taxpayer doesn't satisfy them.

But the OP said that the IRA was a rollover IRA. A "rollover" IRA is a transfer from a 401(k) or similar plan. Be sure not to confuse a rollover IRA with a "conversion" of a Traditional or Rollover IRA to a Roth IRA.
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Yeah yeah, I know the difference, I just read too quickly/wasn't thinking.

So do people agree with me that this 'hypothetical taxpayer' is better off declaring bankruptcy and pretty much going to any length to decrease his debt and avoid messing with retirement funds? Hardly my area of expertise, but it seems to me that you should protect your retirment savings/future at all cost. In fact didn't a recent ruling declare that 401(k)/IRA savings are prohibited from being collected due to suits or bankruptcy? Seems the courts and gov't very much want you to keep them too.
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One thing we don't know is if the OP is filing a seperate business tax form. Maybe they have no "personal" income but just "business" income. It's quite possible that the individual could take the withdrwal, pay the tax liablity, then "loan" the money to the business. Then the "business" fails and the lender can deduct the loss in future tax years.

That said, don't screw with the IRA.

cat
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One thing we don't know is if the OP is filing a seperate business tax form. Maybe they have no "personal" income but just "business" income. It's quite possible that the individual could take the withdrwal, pay the tax liablity, then "loan" the money to the business. Then the "business" fails and the lender can deduct the loss in future tax years.

And what advantage does this provide? The OP still loses his retirement assets. Any loss on a loan to a closely held corporation is treated as a nonbusiness bad debt....deductible as a short-term capital loss. So he gets to recoup his loss @ $3000/yr*marginal tax rate.

A bad deal on all accounts.

Ira

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Any loss on a loan to a closely held corporation is treated as a nonbusiness bad debt....deductible as a short-term capital loss. So he gets to recoup his loss @ $3000/yr*marginal tax rate.

And if the taxpayer files BK with a cap loss carryover, the carryover can be lost in the BK. One of the paybacks for not having to pick up all the forgiven debt as income.

--Peter
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