Accounting & Bookkeeping & Small Business Forum

[Andrea Thompson]

I have a client who took an early dist. from their IRA of $118,000 in 2006. $32000 was for regular payments and is not subject to the 10% early w/d penalty. The remaining $86,000 was reinvested into the auto repair business they started in 2006. I know that if you roll the dist. over to another IRA the 10% is waived. Are there any loopholes for investing the dist. into a small business that would waive the penalty as well? This is a case where the client did not know they would have $8600 in penalties and I am trying to find a way to reduce this. Any ideas would be appreciated.

[BillBro]

This probably comes too late to help for this tax season, but the short answer to your question is "no, there are no loopholes." The reason is that a rollover from one IRA to another still leaves the money in a tax-deferred status. But business investments, of any kind, do not have tax-deferred status. So, by taking the money out of his IRA and investing it in his business, your client changed the tax status of that money. After 60 days, there was nothing that could be done about it. The money must be taxed, AND there is a 10% penalty for early withdrawal.

There are some exceptions to the 10% early withdrawal penalty (for example, if you are over 55 and separated from service with your employer; to pay higher education expenses; for first-time home purchases), but there are no exceptions that prevent the gain from being taxable--even proper withdrawals in retirement are taxable.

My wife and I did this exact thing back in 1988 when we started my business. We were young and knew we had time to rebuild our retirement funds. However, we were clearly informed by the fund manager what the consequences would be, and accepted the tax and penalty as part of the cost of starting our company. So, to some extent, I fault your client for not making the effort to learn the consequences of his choice, and the managers of his IRA for not fully explaining those consequences (if that is what happened--sometimes we hear only what we want to hear).

[Andrea Thompson]

Thank you Bill. That was a very thorough answer and exactly what I was looking for: and exactly what I expected. I just needed a little reassurance. My client is diligently looking for a loophole and I was too, although I was aware of none for this particular situation. We did file an extension for other reasons and my client is aware that an extension is NOT an extension to pay. I was not working with them when they took out the early dist. and whether the investment co. told them the pitfalls of such a withdrawal or not, the outcome remains the same - 10% penalty. I love your explanation of the fact that a business investment is not tax deferred where an IRA is and therefore there is a change in tax status. Very well explained, thank you. I appreciate it!

[BillBro]

I'm glad that I can help. I have to admit that I'm getting pretty good at explaining this, because I have at least one or two clients every year who ask me the exact same question!

[Evangelist Tom Raymond]

Bill took the words right out of my mouth and he explained it prettier than I would have, lol! Good job Bill for beating me to the punchline, lol!