IRS Tough on Early IRA Withdrawals

QUESTION: I’m trying to become a first-time home buyer and am scraping together every penny I can. I’ve been thinking about using my small individual retirement account, about $6,000, for part of the down payment. I know that I was warned about early withdrawal penalties, but what, exactly, can I expect to pay? Do I need to get out my tax returns from the years in which I took the IRA deductions to figure out the hit? Also, I understand that I won’t have to pay the penalties until next April. Is that true? --K.K.

ANSWER: First of all, don’t bother with your tax returns. You shouldn’t need them to figure your tax obligation and early withdrawal penalties.

Basically you should be prepared to pay ordinary federal income tax on the full amount of your IRA withdrawal. (Remember, you haven’t paid taxes on these funds yet; they were put into an IRA on a tax-deferred basis.) In addition, you are required to pay the Internal Revenue Service an early withdrawal penalty equal to 10% of the withdrawal. Furthermore, you may owe state income taxes on any proceeds in your IRA, such as accumulated interest, that have not already been taxed.

Beware: You may also be liable for an early withdrawal penalty from the institution holding your IRA if your IRA is in a time deposit that has not matured when you make the withdrawal. Check with the institution holding your account to be sure.

Now, let’s figure what your total federal tax obligation might be on the $6,000 withdrawal. Assuming that you are in the 28% tax bracket, you can expect to pay $1,680 in ordinary income tax on the withdrawal plus a $600 penalty, for a total of $2,280 to the federal government. Any late taxes would be in addition to this amount.

When do you have to pay this tax? Well, it’s technically due on April 15 of the year following the withdrawal. But be prepared to pay at least a portion of it almost as soon as you make the IRA withdrawal, lest you fall prey to yet another penalty. Why do you have to prepay your taxes? Because the government strictly enforces pay-as-you-go tax withholding, whether it’s on your salary, the proceeds from a stock sale or an early withdrawal from your IRA account.

Here’s how it actually works both for your federal and California state taxes. When you finally get down to computing your tax obligation next year, you must meet at least one test of sufficient tax withholding. Either you must have at least 90% of your total tax obligation withheld during the year--and it must be done during the quarter the income was received, or you must have prepaid an amount equal to your entire federal tax obligation for the previous year. If you fail both tests, figure on getting slapped with another penalty.

Based on our earlier computations, you already know that the federal government is going to want a total of about $2,280 of your IRA withdrawal. You can either pay that amount directly by using an estimated tax form available from the IRS, or you can wait until April 15, if you think your total withholding has been sufficient during the entire year.

It will probably come as little comfort, but you might be interested to know that Congress is studying whether to allow first-time home buyers like yourself to tap their IRA savings for down payments without paying the 10% early withdrawal penalty. The proposal, which faces a very uncertain fate, would not remove the tax obligation on the funds, only the penalty.

Some Tips on Treasury Offerings, Auctions

Q: Every Sunday in the business section of my local paper, I see a list of government securities that refers to a one-year Treasury note and a three-year note, but no two-year note. This doesn’t make sense. Plus, I have never heard of a one-year Treasury note, only a one-year Treasury bill. Can you make sense of this? Also, is there some publicly available calendar the government has for its securities auctions? It sure would help the “little guy” plan for future investing in Treasury securities. --E.N.

A: For starters, let’s run though the various government securities and their proper names, which are often confusing and confused. Treasury bills come in three basic varieties: three-month, six-month and 12-month, or one year. Treasury notes are available with six different maturities: two, three, four, five, seven and 10 years. Currently, new Treasury bonds are issued only for 30 years.

Actual auction dates are not published far in advance. However, the Treasury follows some general guidelines, which we’re including here.

Typically, three- and six-month Treasury bills are auctioned every Monday. One-year bills and two-year notes are auctioned once a month. Three- and 10-year notes and 30-year bonds are usually auctioned in the first week of February, May, August and November. Four-year notes are auctioned near the middle of March, June, September and December. Five-year notes are auctioned in February, May, August and November on the day after the two-year notes are sold. Finally, seven-year notes are sold early in January, April, July and October.

For more precise information, check your local newspaper’s business section or the public information office of your local Federal Reserve Bank branch.

A Look at ‘Negative Amortization’ Loans

Q: I recently purchased a new house using a variable rate mortgage that allows “negative amortization” of the loan principal to keep the interest rate low. I plan to use this feature for at least the next few years while I spend my extra money on repairs to the house. I am wondering how the Internal Revenue Service wants me to account for this negative amortization on my taxes. Do I get a tax deduction in the year the interest obligation is incurred or at some later point? It seems that this interest should be deductible at some some point. --P.A.P.

A: Yes, you’re right. The interest is deductible at some point, and that point is the year in which you actually pay the interest. We should first explain a bit about negative amortization loans and how they work.

Generally speaking, these loans offer below-market interest rates that typically appeal to buyers on a tight budget. However, there is no real savings to the home buyer.

In exchange for keeping the interest rate artificially low, the loan balance owed by the home buyer actually rises. The term negative amortization refers to the fact that instead of the loan balance dropping, as in conventional mortgages, the outstanding balance increases, or “negatively amortizes.”

Of course it’s a bit obtuse, but do you think you could sell a 30-year loan if you said up front that you could easily wind up owing more at the end that you did at the beginning? Theoretically, any increase in the outstanding balance should reflect the amount the homeowner is saving with his artificially low mortgage payment.

At some point, you may decide to “catch up” with your negative amortization by making a lump sum interest payment. That is the year you may deduct the payment on your income tax form. You might also wait until you sell the house to wipe the slate clean. Then you must wait until that point to declare the interest payment as a tax deduction.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.