Possible closing of Roth IRA: Worthwhile tax break?

In 1998, I converted my traditional IRA to a Roth, paying taxes over a four-year period for the privilege. Cost basis was about $40,000, and today the Roth is worth only about $7,000. (Yes, I was too tech-heavy!)

Would it be worth it to close the account to enjoy a tax deduction? My income is under $100,000, and I already have enough other deductions to make itemization worthwhile.

I'm hoping someone can help explain the tax implications, specifically:

1. Do I have to pay a 10% early withdrawal penalty?
2. Do I need to claim the amount as income?
3. Can I claim a loss on my taxes?
4. Do you think closing the account is beneficial to me?

If I'm understanding the situation correctly, it seems I should enjoy some tax savings to alleviate the hurt. Fortunately, I have good savings in a SEP-IRA (to which I can continue contributing), so I'm not so worried about maintaining the Roth.

Thanks!

Good question.

1.) No, you don't have to pay a 10% withdrawal penalty. Penalties are generally applied to earnings only. You've satisfied, additionally, the 5-year requirement on the Roth rollover requirement.

2.) You should not have to claim the amount as income, since you have only received basis. You should have filed an IRS form 8606 advising the IRS of the total amount of your Roth that is considered to be basis. Full liquidation below your orginal basis would be considered to be your tax loss.

3.) Yes, you have a tax loss - your distribution amount will be below your original investment. This should give you a tax loss that can be written off against ordinary income. You might consider having a tax professional prepare your return, given this circumstance.

4.) Is it worth it? I think you have demonstrated a good reason to close the Roth. You could, though, take a full distribution of the $7,000 and get the tax deduction. If your adjusted gross income is below $95,000 (assuming you are single) or $150,000 (if you are married) you can still make a contribution. You could make a $4,000 contribution for 2007, and potentially another $4,000 for 2008 - this would, essentially, get your funds back into your new Roth IRA.

DG

"1. Do I have to pay a 10% early withdrawal penalty?"

I believe yes. If you are not yet 59 1/2. There are a few exceptions shown on Page 65 of IRS Publ 590.

http://www.irs.ustreas.gov/pub/irs-pdf/p590.pdf

"2. Do I need to claim the amount as income?"

No. You already paid the tax on it.

"3. Can I claim a loss on my taxes?"

Yes, to some extent. See Page 66 of IRS Publ 590.

Also read up on the entire section about Roth IRAs.

"4. Do you think closing the account is beneficial to me?"

No.

Right now you are sitting on tax free money on which the earnings are also tax free.

In fact, I suggest you resume making annual contributions of after tax money. Once you do that for 5 more years you'll have tax free earnings on the account for the rest of your life.

Interesting to get these two different perspectives... please keep the replies coming, as I'm grateful for all views (and know I ultimately make my own decision). I should add to the original info that I'm 44 and married, getting by with a big mortgage and not sure I'd be making future contributions to the Roth (I haven't contributed since the conversion from a regular IRA, and have the SEP-IRA as a place to contribute).

"1. Do I have to pay a 10% early withdrawal penalty?"

I believe yes. If you are not yet 59 1/2. There are a few exceptions shown on Page 65 of IRS Publ 590."

Actually, no. If he did the conversion, and then took a distribution of his principal within 5 years of his conversion, the 10% penalty would apply. But, since he's satisfied the 5-year holding period and since none of his distribution is considered 'taxable', the distribution should be both penalty-free, and tax free.

Again, if the intent is to continue saving for retirement, I see no downside in taking the loss on the Roth. You can always contribute to another Roth in the future, and for the most part, you could even re-purchase the same securities if you believe that they have recovery potential. You can re-build your Roth account quite easily through continuing contributions.

DG

After a quick read of Publication 590, I'm thinking Adjuster Jack is right about the penalty. As I'm not yet 59-1/2, it appears it doesn't matter that I've kept the funds over five years. Since I'm withdrawing the money (i.e., taking a distribution) before age 59-1/2, looks like I have to pay a 10% penalty on the current value of $7,000.

That said, I agree with D Greenleaf that it's worthwhile to completely close the Roth. 10% on the current value of $7,000 is only $700. On the positive side, I believe I can take a loss of $33,000 as a miscellaneous deduction on my Schedule A, less 2% of my AGI.

Any thoughts on that analysis? Am I calculating this correctly? And is it true I can always open another Roth in the future if I so desire?

Thanks!

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In 1998, I converted my traditional IRA to a Roth, paying taxes over a four-year period for the privilege. Cost basis was about $40,000, and today the Roth is worth only about $7,000. (Yes, I was too tech-heavy!)

If the distribution conditions are not met, but the 5-year holding period for the allocable conversion is met, the 10% penalty is assessed only against the portion of the distribution includible in income (i.e., the earnings of the Roth IRA) (Reg. §1.408A-6,Q&A-5(a)). Form 5329 is used to report the penalty.

A simple question: Is ANY part of your distribution includible in income?

A simple answer: No.

Since NONE of the distribution is includable in income (it's all basis), and you have met the 5-year holding period following your conversion, you do not have to pay a 10% penalty on your distribution.

The problem with reading IRS publication 590 is that it tells you WHEN the tax MAY apply.... it doesn't give you the circumstances where it does NOT apply.

I think your math is correct.

You are not prohibited from opening a Roth IRA again in the future. I would say, however, you need to close your Roth IRA in FULL for 2007. In 2008, you can recontribute your funds to a new Roth IRA and start the healing process of recontributing to a new Roth IRA.

I hope this helps.

DG

Yes, very helpful - I really appreciate it. I will take a closer look at the issue. I guess I also need to check whether a large deduction will trigger the AMT.

Why wouldn't you be subject to an early withdrawal penalty? You would be subject to a 20% early withdrawal penalty, except for the reasons below

The early withdrawal penalty does not apply to distributions that:

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

trendsetter:

Why wouldn't you be subject to an early withdrawal penalty? You would be subject to a 20% early withdrawal penalty, except for the reasons below

You've resurrected a 3 year-old post—that poster has already dealt with his problem a long time back and won't likely see your response. However, now that you've bumped the post up, let me answer the question to relieve any confusion this thread might create.

First, if a distribution is taken from a qualified plan before age 59 and half, there is imposed an early distribution tax (which the public often calls an "early withdrawal penalty") of 10% (not 20%) for distributions that are not qualified distributions—meaning that they don't meet one of the exceptions to the early withdrawal tax (e.g. disability, death, etc). This assumes that the 5 year period from the date the traditional IRA was converted has passed, as it did in the original poster's case.

But it's important to understand that the early withdrawal tax is imposed only on the portion of the distribution that is includible in income. See IRC § 72(t)(1) and Treas. Reg. § 1.408A-6, Q&A 5. With a traditional IRA, generally ALL the distribution is included in income, which is why any early withdrawl tax also applies the entire distribution with a traditional IRA. That has lead a lot of folks to think the same is true of the Roth IRA. But unlike the traditional IRA, not all of the Roth IRA is included income. With the Roth, the amount you contributed is distributed back to you tax free because you paid tax on that the year you contributed it. The funds put into a traditional IRA are effectively not taxed the year you contribute them because of the deduction you get, which is why all generally all the distribution of a traditional IRA is included in your income.

If the basis of the Roth IRA started out at $40,000 and then the account value dropped to $7,000, then the entire distribution is a return of contributed funds (basis) and none of it is included in your income if you liquidate the Roth at that point. If that distribution was not a qualified distribution, then technically the early withdrawal tax does apply, but since the tax is computed at 10% of the taxable portion of the distribution, the early withdrawal tax works out to be zero (zero taxable distribution x 10% = zero). IRS publication 590 for 2009 does tell you this in the Roth IRA section, stating "Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions." (bolding added). That word "taxable" is key, but often overlooked by folks.

In short, the responses by D. Greenleaf several years ago to the original poster were the correct answers.