Roth IRA: What are early withdrawal penalties paid on?

Question

I am planning on putting some money into a Roth IRA before April 15th, in order to take advantage of the tax credit for lower income people who amass retirement savings.

Let's say I get the Roth IRA, and then close it out 6 months later:
What will I have to pay a penalty on?
Just my earnings, or will there be a penalty on the entire amount I had invested?
Will I have to pay back the tax credit that I took for putting the money in?
Does the tax credit I am speaking of still exist, or did it expire?

Thank you for your help.

Answer 1

This is an interesting loophole that has come up occasionally. The Savers Credit has been made permanent.

Let's say you are under 50 and put $2,000 into a Roth IRA before April 15, 2007 as a 2006 contribution. The amount of $2,000 is the maximum contribution to which the Savers Credit applies. Let's suppose you get a 50% Savers Credit of $1,000 against tax you owe.

Now suppose you close the Roth in September 2007. What happens is:

1. Your original investment of $2,000 is returned to you tax-free.

2. The earnings on that investment are taxable income to you.

3. The earnings are most likely subject to an additional penalty of 10% (there are some exceptions).

4. You keep the Savers Credit and it is not recaptured.

5. You can't play this game again for three years since the Savers Credit looks back two years to see if you have made any withdrawals from retirement savings.

So if your $2,000 were in a 6-month CD at 5% you would earn $50 on it, so have $13 or so of added tax in 2007. You have pocketed the Savers Credit of $1,000 and don't have to return it. But you can't do this again until 2009.