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Although dubbed a penalty, does a Roth-IRA early withdrawal "penalty" effectively lower the short term capital gains rate to 10% instead of linked to your actual income bracket?

As the early withdrawal is levied only the amount withdrawn, it doesn't matter how long a position was opened inside the IRA, long term investment gains, short term investment gains, anything, is taxed at 10% on withdrawal.

Is my understanding correct?

Any other non-retirement account I would fund would also be with post-taxed money. Opening a Roth-IRA with any of those funds (although limited to a maximum contribution per year) and gaining more from the exact same investment strategies effectively lowers the capital gains tax rate from 28%, 35% whatever all the way down to 10%, and even then only on the year that the withdrawal occurs

Correct?

Chris W. Rea
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CQM
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1 Answers1

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You can take out the contributions to your Roth tax and penalty free. That's the good thing.

Anything above the amount you contributed that you withdraw early will cost you ordinary income tax (which is higher than capital gains tax) plus a 10 percent penalty on that amount. So if you have $15,000 in the account and $5,000 is gains and you withdraw $11,000, then you owe tax and penalty on $1,000. The penalty is 10% and your taxes (high taxes!) are added to that. Pretty bad deal.

If you kept it in a normal account and paid capital gains tax, you just pay 15% (or whatever) on your gains and you get to offset income tax with your losses via tax loss harvesting.

So back to your question: your idea works even better than you suggested if you only withdraw up to the amount that you contributed (you pay no tax!). Take out any of the gains and you will be penalized more than you would if you just paid capital gains on them. Leave those in until you are old enough to take them out penalty and tax free.

To me, contributing to a Roth, making a bunch of gains on it, and withdrawing only the contribution part whenever you want seems to make good sense.

farnsy
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