Tax Tips Blog

Edwards writes:

I took approx $5000 out of a Roth Ira that I funded in 2005. I took the money out in 2006 to invest in a startup business (which is going along fairly well). This Roth was funded with a one time contribution.

I miscalculated the amount of funds that would be needed to get this off the ground so I had to hit the Roth.

I received a letter from the IRS asking for me to pay them. I replied to the letter that this IRA was a Roth IRA and because I used after tax dollars AND I had no earnings, that I owed them nothing. I received another IRS letter today that asks me to sign a consent but does not specify what they want. I am not going to sign this.

Question: Did a taxable event occur when I took money out of the roth Ira?

My reply:
Hello Edward.

In general, distributions from Roth IRAs are tax-free until you’ve withdrawn all your regular contributions. After that you’ll withdraw your conversion contributions, if any. When you’ve withdrawn all your contributions (regular and conversion), any subsequent withdrawals come from earnings.

Withdrawals of earnings are tax-free if you’re over age 59½ and at least five years have expired since you established your Roth IRA. Otherwise (with limited exceptions) they’re taxable and potentially subject to the early withdrawal penalty.

You didn’t tell me how old you were when you made the withdrawal or the amount of the withdrawal, just that you “funded” it with $5,000 and had “no earnings”. My guess is that you were under age 59-1/2 when you withdrew the money, prior to it being in the Roth for 5 years, and you did not properly disclose on your tax return the reason for your withdrawal.

If my guess is correct then a taxable event did occur. However, you may not owe any tax if you can satisfy one of the exceptions and/or properly inform the IRS that you had no earnings. It sounds like you did this with your first response to the letter they sent you.

As to their request for “consent” without seeing all the notices that they sent you and your return I would have no idea what they are requesting consent for. It would make sense to me that they wish to verify that you did not have any earnings in your Roth and that is what their content is for, but it’s just a guess and may be incorrect.

I wish you success in your business!

Best wishes,
Gina

Lucille writes:
Dear Mrs. Gina,

I hope that you can give me some advice. I have a Roth IRA (not converted from a traditional) and it has slowly been losing value. What I would like to know if there is a penalty if I withdraw the funds and reinvest funds into an Roth IRA certificate at my local credit union.

Sincerely,
Lucille

My reply:
Lucille,

Hello! Thanks for visiting.

If I’m understanding you correctly, what you’re really asking is if you can change the location of your Roth IRA from wherever it is to your local credit union AND change what you are invested in, both without penalty.

If so, the answer is YES. You can do what is called a “trustee-to-trustee” transfer to transfer your IRA from wherever it is now to your local credit union. Once it has been transfer you can change your investment.

Simply tell your local credit union trustee what you would like to accomplish and they should be very familiar with the rules.

I hope this answers your question.

Best wishes,
Gina

Julie writes: I am thinking of making non-deductible IRA contributions this year and on and then convert to Roth IRA in 2010, as described here: http://finance.yahoo.com/columnist/article/moneymatters/16201I already have a deductible Rollover IRA and Roth IRA. However my income is over the limit for Roth IRA contributions.

Also my company has a 401K to which I contribute. Up to now I saw no advantage to making non-deductible IRA contributions. To make non-deductible IRA contributions do I need to open a new non-deductible IRA account, distinct from my rollover IRA?

If I can make non-deductible contributions to the Rollover IRA and keep a single IRA account, what records do I (or the custodian) need to compute the value of the non-deductible contributions in 2010? By when do I need to open a non-deductible IRA and fund it with 2007 contributions: before Dec 31, 2007 or April 15, 2008?

In 2010 can I rollover the non-deductible IRA into my current Roth IRA or do I need a separate Roth IRA? Thanks in advance for your expertise and time.

My Reply: First, one Roth IRA is sufficient. You do not need to open a separate Roth IRA for this maneuver.

Second, you could convert your entire Traditional IRA beginning in 2010, assuming that Congress doesn’t change the law. If you did this, you would owe income taxes (no penalties) on your deductible contributions and earnings. Thus, if you have a sizable amount in your Traditional IRA, you may want to convert a portion at a time so you don’t throw yourself into a higher tax bracket.

For what is converted in 2010, you can spread the tax over 2 years. For amounts converted after that, the tax will need to be paid with taxes for that tax year.

Third, since you already have a deductible IRA, you need to be aware that you cannot convert only the nondeductible IRA. It’s important to be aware that conversions are done on a percentage allocation only. For example, if you have $10,000 in nondeductible contributions and $90,000 in earnings and deductible contributions between your Rollover IRA and your nondeductible IRA and you convert $10,000, you will be converting $1,000 of nondeductible contributions and $9,000 of deductible contributions and earnings.

Again, you will owe tax on the $9,000 (the portion of your conversion which were deductible contribution and earnings).

Please note: In order to obtain the maximum benefit from this strategy you should have adequate funds to pay the taxes due outside of your IRA account. If you take money from your traditional IRA to pay the tax on the conversion, it’s a taxable distribution subject to the premature distribution penalty (if you’re under 59 1/2). You have until the due date of your tax return to make your nondeductible contributions for the prior year; thus you will have until April 15, 2008 to make your 2007 nondeductible IRA contributions. When you make nondeductible contributions to an IRA you file Form 8606 with your tax return. You will need this form in order to compute the value of the nondeductible contributions.

Best wishes, Gina www.GLGcpa.com