Tax on Early iRA Withdrawal
August 26, 2012 9:14 AM   Subscribe

Looking at cashing in a post-tax IRA for purchase of a second home. Realizing there are tax and penalties to be applied, this still may make sense. Because the IRA funds are post-tax, however, what exactly will be our total tax liability be?

We are looking at a somewhat unique opportunity to purchase a second home at a below-market price and in a market with which we are very familiar. However, we have been extremely diligent in our retirement savings (perhaps too diligent). In order to avoid PMI, we would need to come up with 20% down. One of several options is to take early distributions from two small post-tax IRAs we established. I understand that this is rarely a good idea, but we are way ahead of the curve on retirement savings (we're both in our 40s and have large 401(k) accounts to which we continue to fully fund) and these combined accounts represent less than 5% of our total retirement savings.

Now, YANML, YANMA and I am not soliciting advice on whether this is a wise financial move. However, if these two accounts total $40,000, and we contributed $23,500 in post-tax funds to these accounts over the years, do we only pay income tax on the $16,500 gain (which grew tax-free) or the entire distributed amount? Similarly, to what amount does the 10% penalty apply? IRS instructions and guides are a little vague and only seem to address Roth IRAs. These are simply IRAs to which we contributed, but did not get a tax break because of income caps and the fact that we were fully contributing to our employer-based plans.

Also, we will consult an accountant later next week, but would appreciate any guidance or hive experience in this area.
posted by flyingrock to Work & Money (2 answers total)
I'm not an accountant, and you should vet this with your CPA, but my understanding is that you'd take a hit on both the early distribution end and capital gain end. In other words, if you sold $100,000 of securities which you originally bought at $50,000, you'd pay $10,000, first, to cover the 10% early withdrawal penalty, but you'd also incur a second tax liability at the same time based on the $50,000 profit you made from the stock sale, which you'd have to calculate based on whether it was a longterm or short term gain. So, your tax bill next April would be high under this scenario.

In some instances, you may be able to take out money from the IRA, then roll it back into the IRA in one or two months without incurring a penalty. Again, you should ask your CPA about this.
posted by Gordion Knott at 2:54 PM on August 26, 2012

I don't have a specific answer to your question, but perhaps this might impact your decision: If you are funding your IRA post tax, you can transfer that money to a Roth IRA (regardless of income caps). This is called a backdoor Roth IRA.

When you do that, you will be taxed, proportionally based on how much you paid in pre vs post tax, I think the interest you have gained might hurt you a little though.

My point is this (and I say this without checking the full details so I might be wrong), if you withdrew the interest (taking whatever tax hit that is), converted the remainder to a Roth (at no charge whatsoever), you could find yourself with the balance sat in the Roth IRA--which is far, far better than having it in a 401k (since it is not taxed upon withdrawal).

It also means you can continue to do backdoor conversions each year (which you may consider better for you than paying into the 401k depending on your age).

I appreciate you need the cash, but it might work out better as I've described: taking out the interest from the IRA, doing the Roth conversion, and taking out any remaining required funds from your 401k.
posted by NailsTheCat at 8:07 PM on August 26, 2012

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