Roth IRA Early Withdrawal and Penalty

TaxSmarty has been flooded with similar questions asking the following: “I have a Roth IRA account and need to withdrawal money early. What is that going to cost me?”

Any distributions of investment gains taken from your Roth IRA prior to age 59 1/2 are considered early withdrawals.

Look at the term “investment gains”. What does this mean? Investment gains are the monies earned (interest, dividends or capital gains) from your original contribution. The next question is – Why is this important?

It is because if you withdraw any money YOU contributed (original contribution) it is tax free. The reason is that you contributed to you Roth IRA with after-tax funds. No need to pay tax twice on your money!

Be careful that you don’t withdraw the “investment gains”. This is where it gets a bit tricky. If you withdraw any investment gains prior to age 59 1/2, then you'll owe income taxes and a 10% early withdrawal penalty on those funds, the “investment gains”

Here is an example:

At age 21, you open a Roth IRA and contribute $5,000. You never make any additional contributions.
Fifteen years later, you decide to close the account. It's now worth $15,000.
How much of that $15,000 do you get to keep?

By closing the account early, you don't owe any taxes or penalties on $5,000 of the $15,000.

Why is this?

Because you can withdraw your original contribution any time both tax-free and penalty-free.

But the remaining $10,000 is considered an investment gain. As a result, it's subject to income taxes and a 10% Roth IRA early withdrawal penalty.

To recap:

An early withdrawal of your original contribution is always tax-free and penalty-free.

An early withdrawal of your investment gains prior to age 59 1/2 is subject to a 10% Roth IRA early withdrawal penalty as well as applicable income taxes.

The 5 Year Rule:

Even if you reach age 59 1/2, you still need to meet one more requirement before you can withdraw investment gains tax-free and penalty free.

What is this requirement?

It is the federal tax code's “5 year rule”.

This means your Roth IRA needs to be funded for at least 5 tax years before you can make tax-free and penalty-free withdrawals.


Here is an Example:

You are 59 yrs old and you decided to convert your Traditional IRA to a Roth. You do that in the year 2007, paying the applicable income taxes required by such a conversion. The funds continue to grow and in 2010, at age 62, you decide to withdraw those funds.

Will you be able to withdraw tax free since you pass the age of 59 ½?

No!

You still haven't met the 5 year rule for that portion of your money which you the converted. You converted in 2007 and 2010 is only 3 yrs. You need to wait two more years before you can withdraw all the money tax and penalty free. The original contributions can still be withdrawn tax-free and penalty-free but not the investment gains.

Early Withdrawal Exceptions:

There other cases when you can withdraw investment gains from your Roth IRA without having to pay taxes and penalties that are specifically listed in the tax code. They are as follows:

1. IRA owner's disability. (This can be a very narrow definition, so don't consider a Roth IRA distribution for a disability until you review IRS Code Section 72(m)(7) and IRS Publication 590.)
2. IRA owner's death.
3. Withdrawals are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
4. Paying for unreimbursed medical expenses that exceed 7 1/2% of your adjusted gross income (AGI).
5. Paying medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
6. Paying the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
7. Paying for the qualified expenses of higher education for the IRA owner and/or eligible family members.
8. Paying back taxes because of an Internal Revenue Service levy placed against the IRA.

TaxSmarty online software can guide you through these tax speed bumps. It is easy and will ensure your Roth IRA distributions are handled properly. Check us out for free at www.taxsmarty.com.

Tax Write-Off Ideas

Our tax customers often ask us: “What can I deduct to lower my tax bill”? Below we have listed 46 ideas that may work for you. To take full advantage of the ideas that could benefit you, use TaxSmarty.com online tax software powered by CompleteTax. It will be your guide to ensure you receive the best benefits from the IRS !!

1. Fees paid to a tax preparation service like your accountant or TaxSmarty online software fee

2. Fees paid for an IRS Audit

3. Rehab treatment services like Alcohol and Drug

4. Fees paid to have items that you donate to charity appraised (valued)

5. Fees paid to have items valued that were lost in a casualty such as a fire or flood

6. Theft or Casualty losses

7. Phones (this is related to using your phone for work as required by your employer that is not your only (read: personal) phone line into your home)

8. Do you travel for business? – cleaning or laundering service while traveling

9. Certain closing costs for buying or selling a rental property or refinancing that property

10. Home computer depreciation if the computer is used for business or taxable investing

11. Contact lenses, hearing devices and prescription eyeglasses

12. Prescription expenses for contraception

13. Expenses associated with searching for a new job in your present occupation, including money spent for resume prep and employment outplacement agencies.

14. Labor Union Dues

15. Employer required expenses for education, maintaining your licenses, improving skills etc.

16. Your contributions to a state run disability fund.

17. Moving expenses (related to moving for work)

18. Money paid for self employment tax

19. Paid Foreign taxes

20. Fees paid for a safe deposit box that holds investments (i.e. stock certificates)

21. Childbirth preparation class expenses if the instruction is related to obstetrical care

22. Expenses paid for foster care

23. Gambling “losses” (deductible as an itemized deduction up to the amount of gambling winnings claimed)

24. Expenses paid to a hospital for services like: lab work, therapy, nursing services, and surgery

25. Home energy improvements such as a qualified HVAC system, insultation, windows and doors, etc. (this is a good one because it's a credit directly deducted from taxes paid as opposed to a deduction from taxable income)

26. Impairment-related work expenses for a disabled individual

27. Investment advisory fees

28. Separately billed IRA trustee admin fees

29. Expenses due to having lead paint removed from your home

30. Fees incurred in connection with collecting or obtaining alimony

31. Long-term care insurance premiums

32. Travel expenses incurred from having to travel and perhaps be lodged away from home due to medical reasons

33. Prepayment penalties and late fees for your mortgage

34. Expenses related to charitable activities such as travel or supplies purchased by you used in your charitable activities

35. Health insurance premiums

36. Monies paid for penalties associated with early savings withdrawals

37. Personal liability insurance for wrongful acts as an employer

38. Points (and other applicable closing costs) for home mortgage or investment property refinancing

39. Expenses for work-required clothing

40. Taxes associated with the sale or purchase of Real Estate

41. Certain seller-paid closing costs paid on your behalf

42. Special equipment if you are disabled

43. Special schools and separately stated fees for medical care included in tuition

44. Personal property taxes charged by your state on cars and boats

45. Professional association fees and subscriptions to professional journals

46. Theft or embezzlement losses

This list is not exhaustive, nor are all of these items necessarily in the tax code. It is a collection of items for you to consider and consult with a qualified tax preparer to determine their applicability to your situation. Your friends at TaxSmarty.com look for ways to save money from time to time, so for our customers and blog readers, this list is an attempt to provide some ideas for this very thing.

I don't know if it is worth filing? Should I File a Tax Return?

This is a big question. Do I or don’t I? Your friends at TaxSmarty.com answer this question below. Make sure you read the last sentence, then decide.

Your filing status is determined on the last day of the tax year. Generally, your filing status depends on whether you're considered unmarried or married. Marital status is determined by state law with one important exception: For federal tax purposes, same sex marriages are not considered legal marriages. Your options for filing are:

* Single. You can file as Single if you have never been legally married under U.S. laws, you are legally separated or divorced according to the laws of your state, or were widowed before the last tax year and did not remarry during the tax year.

*Married Filing Jointly. You can file as Married Filing Jointly if you are married as of the last day of the tax year, whether or not you're living together, or if your spouse died during the tax year and you did not remarry.

* Married Filing Separately. You can file as Married Filing Separately if you are married as of the last day of the year.

* Head of Household. You can file as Head of Household if you are single, divorced, or otherwise unmarried at the end of the tax year, and (1) you paid more than 50% to keep a home for the entire tax year for a parent who was a dependent OR (2) you paid more than 50% to keep a home for the entire tax year with your dependent. Filing as Head of Household can be tricky; special rules and exceptions apply.
Qualifying Widow(er) With Dependent Child.

* You can file as a qualifying widow(er) with dependent child for two years following the year your spouse died.

Your age is calculated as of the last day of the tax year -- with one exception. If you turn 65 on Jan. 1, 2011, you're considered to be age 65 on the last day of 2010. And while it generally isn't a good thing to age a little faster, this allows you to use the higher income thresholds to determine whether you must file a return.

Taking those three factors into consideration, you determine whether you must file as follows:

* If you file as single and you're under the age of 65, you must file a return if your gross income is at least $9,350; if you are 65 or older, you must file a return if your gross income is at least $10,750.

* If you file as married filing jointly, and both spouses are under the age of 65, you must file a return if your gross income is at least $18,700; if both spouses are 65 or older, you must file a return if your income is at least $20,900. If one spouse is 65 or older, you must file a return if your income is at least $19,800.

* If you file as married filing separately, you must file a return if your gross income is at least $3,650, no matter what your age.

* If you file as head of household and you are under the age of 65, you must file a return if your gross income is at least $12,000; if you are 65 or older, you must file a return if your gross is at least $13,400.

* If you file as qualifying widow(er) and you are under the age of 65, you must file a return if your gross income is at least $15,050; if you are 65 or older, you must file a return if your gross is at least $16,150.

Special considerations apply for certain additional taxpayers:

* A child who is under the age of 19 or who is a full-time student under the age of 24 earning only interest and dividends may report that income on his or her own return or on a parent's return. For 2010, the amount of taxable investment income a child can have without it being subject to tax at the parent's rate has increased to $1,900. If a child earns income by performing services, from babysitting to acting, the income is reportable. A parent can elect to include the child's income on the parent's return. If this election is made, the child does not have to file a return.

* Self-employed persons must file a return if your gross income meets the age, income and filing status criteria above, or if your net earnings from self-employment totaled $400 or more. Self-employed persons who have church employee income of $108.28 or more must also file a return.

* If you are a resident alien for the entire year, you must file a tax return following the same rules that apply to U.S. citizens. If you are a nonresident alien or a dual-status taxpayer, different rules may apply. Check Publication 519 for more information.

* Even if you don't have to file, there are circumstances under which filing a federal income tax return makes sense. You may be entitled to a refund if you had federal income tax withheld from your pay or made estimated tax payments or if you qualify for one of a number of credits, including the Making Work Pay Credit, Government Retiree Credit, earned income tax credit, child tax credit, the American opportunity credit, first time homebuyer credit or health care coverage credit.

Still not sure whether you should file? Consider this statistic from the 2010 filing season: Out of the 139 million returns filed, 108 million were due a refund. The total amount of refunds due was $316 billion, making the average refund over $2,900. Don't lose out.

TaxSmarty
Taxes have never been this easy!