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Roth IRA vs Regular Individual Account
Old 07-12-2012, 09:40 PM   #1
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Roth IRA vs Regular Individual Account

HI ER peeps

I am a college senior who at the beginning of the way to my early retirement. Yet, there is one thing I concern the most at this stage, which is choosing the best fit investment platform for myself. I have been trading options for few months in my Roth IRA account, but I just found out there is a 10% penalty along with tax treatment for early withdrawal. However, I could not find further information about what type of tax is that, and what is the rate for it. Thus I am think if it would be better for me to trade in regular individual account instead; because I will need the money for the down-payment of my first house and real estate investment in the future. If, just as an assumption, I could gain 40% per year with options, which type of account I should be trade in? Could you guys please give me some advice?

Thanks!
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Old 07-12-2012, 10:35 PM   #2
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Like the name implies, a Roth IRA (Individual Retirement Arrangement) is a retirement account. Withdrawals of any earnings in the account taken before your are 59 1/2 years old will be taxed as regular income and an additional 10% penalty applies to any earnings withdrawn.

You can always withdraw your previous contributions with no tax due or penalties, because your contribution dollars have been taxed already. Roth IRA accounts are funded with after-tax money.

So if you put in $5000 and made your 40% by trading, you now have $7000 in the account. If you pull out $5000, no harm-no foul because you are withdrawing your previous contribution. If you take out the full $7000, you will owe income tax on the $2000 (at your personal marginal tax rate for that year...10% or 15% or 25% or whatever, depends on your other income) PLUS $200 (the 10% penalty for early withdrawal).

If you are willing to let the earnings stay in the account, it's a great way to accumulate savings for retirement that will never be taxed. If you'll need to withdraw the earnings for other purposes, maybe a straight-up investment account would be better.
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Old 07-12-2012, 10:52 PM   #3
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Originally Posted by ljrtan View Post
. I have been trading options for few months in my Roth IRA account, but I just found out there is a 10% penalty along with tax treatment for early withdrawal. However, I could not find further information about what type of tax is that, and what is the rate for it.
You are probably confusing the attributes of a traditional IRA (TIRA) with that of a Roth. TIRA withdrawals are generally subject to income tax. The rate depends on what other income you have. Have you calculated what your net worth will be if you continue to compound at 40%/yr? Perhaps you could ER in another 10 yr. I'd be inclined to dial that rate down to 30% so you'll be more mature when you ER
.

You might want to visit the Bogleheads.org site for another investment philosophy. Kind of boring , actually, but you might remember the old story of the tortoise and the hare......................you might want to bet on 2 horses , rather than 1.
http://www.bogleheads.org/ up at the very top, you'll find the wiki, getting started, and investing philosophy tabs that might be interesting (someday, if not right now)
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Old 07-13-2012, 07:38 AM   #4
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fairmark.com has a good explanation of topics like this (Taxable Distributions from Roth IRAs is specific to this topic). You won't pay the 10% penalty if you use it for a first time home purchase. As Red_y explained, you will pay taxes on the earnings.

If you just want to take back out the original investment, a Roth IRA seems ideal for this, because you'll still have the earnings in the tax free account. But if you need to take everything, you'll pay regular income tax rates, rather than capital gains tax rates which may be lower if you hold the investment for a year.
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Old 07-13-2012, 09:41 AM   #5
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the "first" time homebuyer's withdrawal is taken from earnings. And it is capped at $10k lifetime.

There is a basis recapture the following year, So you'll loose up to $10k in basis. but, say you had $20k in your account, $10k contributions, $10k basis. You can take all $20k (in the same year) for a "first" time home purchase.

But, if you want to take $10k this year as your "first" time home purchase and wait until the dust settles the following year to use the $10k in basis for something else, you'll be in a world of hurt, as you will get hit up with the 10% penalty plus taxes at your marginal tax rate.

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Old 07-13-2012, 11:49 AM   #6
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the "first" time homebuyer's withdrawal is taken from earnings. And it is capped at $10k lifetime.
Right, so you could take your contributions back at no tax cost, plus up to $10K in earnings taxed at your marginal tax rate, with no 10% penalty, as long as you actually use it to buy a house within 120 days.

Quote:
There is a basis recapture the following year, So you'll loose up to $10k in basis. but, say you had $20k in your account, $10k contributions, $10k basis. You can take all $20k (in the same year) for a "first" time home purchase.
I thought basis and contributions were the same thing, except that your basis is reduced by any administrative expenses. Maybe I'm reading it wrong, but it seems like you are calling them 2 entirely different things, that the 20K in the acct is made up of 10K in contributions + 10K in basis. I don't understand what you're trying to say.

Quote:
But, if you want to take $10k this year as your "first" time home purchase and wait until the dust settles the following year to use the $10k in basis for something else, you'll be in a world of hurt, as you will get hit up with the 10% penalty plus taxes at your marginal tax rate.
I don't understand what you're saying here either. There's no penalty or even taxes for withdrawing from your basis. When you say basis, do you mean earnings? Maybe I'm wrong, but I don't think those are the same things at all. I'm just trying to understand this first time home purchase rule since my son may use it in a few years, and after reading your post, I'm not sure I understand it anymore.
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Old 07-13-2012, 12:34 PM   #7
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sorry, I have my head up my butt. trying to w*rk and type fast...

correct, basis and contributions, same thing, sort of. for all intents and purposes, they are the same, but you can still have less basis than the amount you contributed.

example: ronocnikral has $20k in his roth IRA account, $10k contributions and $10k earnings. In 2010, he will make an unqualified distribution from earnings of $10k, not having to pay taxes/penalty because this is for his "first" time home buyer. In the same year, he will take another $10k unqualified distribution without tax/penalty because this is the amount of his basis/contribution. no tax and/or penalty on any of the $20k.

If you take the "first" time home buyer's distribution and plan to leave basis for whatever reason in the future, the amount of the first time home buyer's distribution will be recaptured in subsequent years.

example: same as above, except ronocnikral will ONLY takes the "first" time home buyer's distribution in 2010. No contributions to Roth IRA accounts are made afterwards. in 2012, he wants to take out the $10k (make up any reason you like) of contributions. He works through form 8606, he quickly finds out he has no basis left AFTER the "first" time home buyers distribution. If he wants to take this $10k out, he will need to pay tax and penalty.

I think this all shakes out within the first few lines of form 8606, where the "first" time home buyer's distribution is explicitly mentioned right on the form itself. No mention in pub 590, of course, publications from the IRS are non-binding. So is my tax advice....
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Old 07-13-2012, 12:38 PM   #8
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edit: i apologize, the "first" time home buyer's distribution is qualified, not unqualified. that is why the roth ordering rules don't apply...

edit (again): and why your account must be at least 5 years old.
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Old 07-13-2012, 01:09 PM   #9
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OK, I think it all makes sense now. Thanks.
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Old 07-13-2012, 01:17 PM   #10
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from Alan S on a forum post over at fairmark:

Quote:
If you actually use the distribution for a qualified first home, you trigger some of the most complex provisions of Roth IRA distributions.
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Old 07-13-2012, 03:13 PM   #11
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Originally Posted by ronocnikral View Post
There is a basis recapture the following year
At first I didn't understand what you mean by basis recapture, but thanks for clarify it after.

Quote:
Originally Posted by ronocnikral View Post
If you take the "first" time home buyer's distribution and plan to leave basis for whatever reason in the future, the amount of the first time home buyer's distribution will be recaptured in subsequent years.

example: same as above, except ronocnikral will ONLY takes the "first" time home buyer's distribution in 2010. No contributions to Roth IRA accounts are made afterwards. in 2012, he wants to take out the $10k (make up any reason you like) of contributions. He works through form 8606, he quickly finds out he has no basis left AFTER the "first" time home buyers distribution. If he wants to take this $10k out, he will need to pay tax and penalty.
So base on my understanding, I should either take out my contribution money first, or take both the contribution money and the 10k for "first time home buying" at the same time in order to avoid the penalty and tax, right?
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Old 07-13-2012, 04:46 PM   #12
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technically, it would all need to be done in the same calendar year. The IRS won't know when each withdrawal happens unless you are audited. And even then, there is nothing in the rules that says one withdrawal must occur before the other when they all happen in the same calendar year.

Of course, I'm just an engineer, not a tax lawyer/guru/advisor. so, ymmv. It's important to note the quote from Alan S above. Here's another from Ed Slott's forum:

Quote:
I think these examples show how difficult to explain this is, and why Pub 590 makes absolutely no attempt to summarize this under their definition of the ordering rules.
Ed Slott and Company IRA Discussion Forum • View topic - Roth Basis and First Time Homebuyer

and another from Alan S (again)

Quote:
If you still need to tap your Roth, and you probably know this is not a real good idea
I value the opportunity to invest within a Roth (especially at a low marginal tax rate) much more than having a house. Of course, I married a woman who already owned one (and came with over $100k in equity). So, it is a conundrum I have never before faced.
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Old 07-13-2012, 06:08 PM   #13
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Again, you need to meet the 5 yr criteria to avoid taxes on the earnings.

If you plan to pull out all of the money in less than 5 years, I would just use an ordinary taxable account. If some of the earnings are LTCG, you pay less taxes; if you lose money, you'll get a capitol loss to write off; even if you have short-term capital gains, you might be better paying taxes now as a student and also spreading them out over the next years rather than realize them all at once when you withdraw since you'll probably be in a higher tax bracket after you graduate; and it sounds like taking the Roth distribution is complicated when you file your taxes.

Not going to buy a house until 2017 (assuming you opened the Roth this year)? The Roth sounds better, as long as you don't lose money, and as long as you can live with the $10K earnings distribution limit.

I would really encourage you to read the links we've provided above to understand it all yourself and not rely on our potentially faulty interpretation.
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Old 07-13-2012, 07:28 PM   #14
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I think runningbum correctly said the 5yr criteria to avoid taxes. I would like to stress, that if under 5 yrs, you cannot escape tax, which is at whatever your marginal rate will be that year. But, you will NOT have to pay the additional 10% penalty (on the $10k). This is taken off on form 5329, line 2. So, if under 5 yrs, tax, no penalty. Over 5 yrs, no tax, no penalty.

If Alan S is correct about this being extremely difficult, one of the more difficult, my hope is a SEPP is easier.
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Old 07-13-2012, 10:24 PM   #15
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Again, you need to meet the 5 yr criteria to avoid taxes on the earnings.

If you plan to pull out all of the money in less than 5 years, I would just use an ordinary taxable account. If some of the earnings are LTCG, you pay less taxes; if you lose money, you'll get a capitol loss to write off; even if you have short-term capital gains, you might be better paying taxes now as a student and also spreading them out over the next years rather than realize them all at once when you withdraw since you'll probably be in a higher tax bracket after you graduate; and it sounds like taking the Roth distribution is complicated when you file your taxes.

Not going to buy a house until 2017 (assuming you opened the Roth this year)? The Roth sounds better, as long as you don't lose money, and as long as you can live with the $10K earnings distribution limit.

I would really encourage you to read the links we've provided above to understand it all yourself and not rely on our potentially faulty interpretation.
I did read those links, and done some research by my own. But I was confused by the five year criteria before. I thought it is only for people who withdraw money when they are already "qualify" to do so. It just that if the account is less than 5 years, even the person reached age 59 1/2, disabled or death, he needs to pay for tax but not penalty; while for people who is not "qualify" for withdrawal, it will depends on if the person meets "other exceptions" or not, to decide if he need to pay for tax but not penalty or both. However, I just found out "first time home buying" is also consider as one of the "qualifications".

And, indeed, I did open the account this year, but I was planning to buy my house within the next four years. Now, it seems like I cannot even use the benefit as a first home buyers...

But anyways, thanks all for the advice! I think what I will do is that I will keep putting the max. amount into my Roth for short options trade, and other money into my regular account for long term investments. And when I need the money for my first house, I will withdraw only my contribution from Roth.

There is still one thing that I am thinking though...if I am going to buy my "first" housing under the tittle of L.L.C., will I still qualify for the $10k withdrawal if I buy another house later in the future? Since I didn't buy the "first" house under my name
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Old 07-14-2012, 10:21 AM   #16
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pub 590 does a decent job describing who a "first" time homebuyer is. I would consult that. pg 51.



www.irs.gov/pub/irs-pdf/p590.pdf
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Old 07-15-2012, 08:57 AM   #17
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pub 590 does a decent job describing who a "first" time homebuyer is. I would consult that. pg 51.



www.irs.gov/pub/irs-pdf/p590.pdf
Oh wow! Thanks! That is exactly what I was looking for
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