Tax question-- I withdrew funds from a Roth IRA (before the 5 yr mark) to make a down payment as a first time?

Question

home buyer, in 2005. I am many years less than 59. My "advisors" had not informed me that this sort of early withdrawal is only tax exempt if it is made at least 5 yrs after the creation of the Roth (the Roth started in 2002); I thought it was tax exempt just because it was used as a first time homebuyer cost. I made this unfortunate finding just now, as I research my reply to the CP2000 the IRS sent me a few months ago, stating that I owe them $900 in taxes. My question: is this true? Am I screwed? I have also read that your contributions to the Roth can be withdrawn "anytime" without tax or penalty. Can this be true? If so, and if contributions are the first to be withdrawn, then didn't part or all of my $3000 distribution in 2005 actually consist of contributions, so that part or all of it should be exempt from tax? Anyone?

Answer 1

I assume the contributions to your Roth did not come from another retirement plan.

If you had previously contributed $3,000 to your Roth, the full $3,000 distribution should be tax-free. However, when you have a distribution from a Roth, you are required to attach Form 8606 to your tax return. Since you did not do this, the IRS is assuming the the entire distribution is taxable, hence the $900 tax and penalties.

To fix this, you can amend your return and attach a properly filled out 8606, or it may be possible to send in the 8606 separately. Take the letter you received to a tax preparer who will figure out which course of action is appropriate.

Although you used your distribution for a home purchase, I recommend you not put this on your 8606, since the entire distribution is tax-free as long as you made that amount of contributions. You have one life-time $10,000 exclusion from penalties for the first-time homebuyer, you may as well keep that entire exclusion should you need it in the future.

See Form 8606 for 2005, Part III.

http://www.irs.gov/pub/irs-prior/f8606--2005.pdf

line 19: $3,000
line 20: 0
line 21: $3,000
line 22: enter the amount of all your contributions
line 23, 24, 25a: 0

Answer 2

You are seeing the downside of the ROTH.

When you funded the Roth in 2002, were these regular contributions or IRA rollover contributions? (Were forms 8606 filed?)

How much money in the Roth were after tax money (contributions and rollover) vs. earnings?



From the CP2000 what entries are you actually seeing? There should be line items that describe form 5329 penalties as well as possible line items that change your taxable income and income tax.

If you rolled money over and took it out before 5 years were up, there is a 10% tax on the entire distribution. If some of the money is actually from earnings, the earnings *also* gets taxed as ordinary income.

Answer 3

Your contributions would come out tax and penalty free. Only the earnings would be subject to tax and penalty.

You should have filed Form 8606 with your return showing the basis (contributions) in the Roth IRA. Without this form, the IRS can only assume the basis was 0.00.

You will need to fill out a 8606 and include it with your response to the letter. It may be time to see a professional.