Thursday, February 05, 1998
The fourth in a running series of special tax articles.
The New Roth IRA - Part IV
Penalties on Earnings from Contributions
Unless an exception applies, any distribution from a Roth IRA before an individual reaches age 59 1/2 will be subject to an "early withdrawal penalty" in the amount of 10% of the amount of the distribution required to be included in the taxpayer's 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 also 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 1/2 and since Jim did not meet any of the exceptions, he 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 he will pay a penalty in the amount of $150 on the early distribution. This could be a very steep price to pay.
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 owner 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 or not you itemize your deductions).
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.
These are the same penalty exceptions that apply to a regular IRA. For an additional discussion on these penalty exceptions, read IRS Publication 590 at the IRS website (http://www.irs.ustreas.gov).
Penalties on Rollovers 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 article).
But rollovers have a different twist. And the rollover rules are different for 1998 rollovers as compared to 1999 or later rollovers.
1999 and Later Rollovers
For a rollover that takes place in 1999 or later, the 10% penalty WILL apply to both rollovers and earnings in the Roth IRA account if the five-tax year rule has not been met. (We discussed the five-tax year rule in Part III, so you might want to take a few minutes to review it at this time).
Example 1: Mary, who is 40, makes a qualified rollover from her regular IRA to a Roth IRA on December 30, 1999 in the amount of $20,000. Since Mary is in the 28% marginal tax bracket, she will pay $5,600 in income taxes in 1999 relative to this rollover. Mary withdraws the rollover "principal" of $20,000 on January 1, 2004. There is no tax or early withdrawal penalty on this amount, even though no other penalty exceptions apply. Why? Because the five-tax year rule was met.
Example 2: Using the same facts as above, but Mary takes her $20,000 distribution in December 2003. While Mary will not owe any income tax on this distribution, Mary WILL owe a 10% early withdrawal penalty in the amount of $2,000 on this distribution (assuming that none of the penalty exceptions are met). Why? Because the five-tax year rule was NOT met.
Example 3: Using the same facts as above, but Mary takes her $20,000 distribution in January 2004, and Mary also takes a $6,000 non-qualified distribution from her Roth IRA earnings at that same time. Mary will NOT pay tax or penalties on the $20,000 principal withdrawal, but she WILL pay additional tax on the $6,000 of earnings and will also be charged a $600 penalty on the early withdrawal of those earnings (assuming none of the penalty exceptions can be met). Why? Because the distribution of the earnings was a non-qualified distribution and was made before age 59 1/2.
Remember (in Part II) we discussed that 1998 is a special year for Roth IRA rollovers in that the taxable income must be spread over a four-year tax period. Well, 1998 is also a special year for IRA Rollover penalties. In addition to the regular 10% early withdrawal penalty, there will be an ADDITIONAL 10% penalty that will be imposed on early withdrawals made from 1998 rollovers. This additional 10% penalty will be assessed to penalize you for spreading your taxable income over a four-year tax period. This means, in effect, a 20% early withdrawal penalty could be imposed on "early" withdrawals from a Roth IRA rollover that took place in 1998.
Example 1: Jim, age 35, makes a qualified rollover contribution from his regular IRA to a Roth IRA in the amount of $60,000 on December 30, 1998. Jim is required to spread this income over a four-year period, and is required to report $15,000 per year in 1998, 1999, 2000, and 2001. In January 2003, Jim takes a principal distribution of $40,000. Jim will not be assessed any tax or penalty on this distribution. Why? Because the five-tax year exception has been met.
Example 2: Same facts as above, but assume that Jim takes this $40,000 distribution in 2002. Jim will pay no income tax on this distribution. But, since the five-tax year period was not met, and assuming that none of the penalty exceptions are met, Jim WILL pay a 20% early withdrawal penalty of $8,000 on this distribution. This 20% represents the normal early withdrawal penalty of 10% PLUS the additional 10% early withdrawal penalty assessed against 1998 rollovers.
Example 3: Same facts as above, but assume that Jim takes the entire $60,000 principal distribution in 2002, plus an additional $12,000 that represents a non-qualified distribution from the Roth IRA earnings. Assuming that no penalty exceptions apply, Jim will get smacked with a $12,000 penalty on the principal (20% of $60,000) and a $1,200 penalty on the earnings (10% of $12,000). Jim will also pay regular income taxes on the earnings of $12,000 in 2002. Why? Since the five-tax year exception was not met and both the principal and earnings were taken out "early," the principal is subject to the increased penalty and the earnings are subject to both taxes and penalties. As you can see, this is a very severe price to pay for this distribution.
IRS Ordering Rules
It gets worse. The IRS has stated that contribution withdrawals will be treated as being distributed in the following order:
1. First from qualified rollover contributions made from a regular IRA to a Roth IRA in 1998.
2. Next, from any other qualified rollover contribution (1999 and later rollovers).
3. Finally, from any contribution to a Roth IRA other than a rollover contribution (regular contributions).
What does this mean? It means that if a distribution is made from a Roth IRA before the five-tax year exclusion date, and if the Roth IRA contains mixed contributions (some from regular contributions, some from rollovers), the distribution would be deemed to be made from the type of contribution that would result in the highest tax penalty first.
Do you now see why the IRS has recommended that that you use separate Roth IRA accounts to hold qualified rollover contributions? I certainly hope so. Combining rollover accounts with regular contribution funds could subject you to penalties far in excess what you might have paid if separate accounts were maintained should you have to take the funds "early."
There are a number of other issues regarding Roth IRAs that we have not discussed in detail. And while those provisions may be important to you, we have discussed the major Roth IRA rules in enough detail to make this the final installment on the Roth IRA. Of course, if you have any additional questions on the Roth IRA, I'll be glad to try to answer them on the Tax Strategies message board.
Message Board Q&A
Now let's look at a few questions from the Tax Strategies message boards.
1. Kpatt, looking for a tax deductible method to finance his auto loan wonders
Q: I am in the market for a new (or used) car and have been considering various financing options. It occurs to me that the best option would be to take out a home equity loan for the entire amount of the purchase, so that the interest would be tax deductible. As long as the sum of my mortgages is less than the value of my home, I don't see how I can lose.
The fact that I don't see too many (any) other people doing this makes me wonder if I'm missing something? Does the IRS care how I spend the money?
A: Well, in my experience, I have seen a BUNCH of people use this financing technique. They have used a home equity loan to pay off credit cards, purchase vehicles, and otherwise turn non-deductible interest into deductible home mortgage interest.
The only way you can LOSE is if you don't quickly pay back the home equity loan. Most automobile loans run 3 to 5 years. But your home equity loan may be spread out over a longer period of time. If you fail to repay your equity loan, in a few years you'll find that you have to buy another auto, but don't have any equity remaining in the home equity account. You may then have both a new car loan AND the remainder of your home equity loan left to pay. You want to be careful not to pyramid your home equity loan and make it a problem that could jeopardize your home if you can't make the payments.
Remember: If you have a car loan, the worst that can happen is that your car is repossessed if you can't make the payments. But if you finance your car (or credit cards) with a home equity loan... and then find that you can't make the payments, you may be out looking for an apartment.
So you really need to make sure that this is something that you are comfortable doing. But purely from a tax standpoint, it is a good thing in many instances.
For additional information on the deduction of home equity loan interest, read IRS Publication 936.
2. Weesnerc, looking to double dip some tax credits, asks
Q: Will a person, assuming they meet the income requirements, be able to take both the Child Tax Credit and the Dependent Care Credit during 1998?
A: Yup. Each has its own rules, regulations, and qualifications. It is very possible that you can qualify for both and receive a credit for both. One does not void the other.
3. WHLMAN, thinking about the use of his vehicle for business purposes, asks
Q: In 1997 the maximum allowable rate for car mileage was 31.5 cents. What is it for 1998?