Early IRA withdrawal penalty offset by tax credits?
I have a client that sold some properties last year as short sales. Upon the sale of these he was able to realize $150k in real estate losses. This was able to offset the $65,000 in canceled debt that he received a 1099-C for. He also had to take out $35k out of an IRA to settle with one of the banks (he is pre-59.5). The 150k minus the 65 and 35 gives him 50k that he can offset against his income, but the question I have is regarding the 10% or $3500 early withdrawal penalty from his IRA. If his taxable income is so low because of itemized deductions and the 50k write off on his income, would tax credits like the child tax credit offset that penalty or does he have to pay the penalty regardless?
Permalink Submitted by Peter Lingane on Mon, 2011-01-31 16:02
Take a look at page 2 of the 2010 Form 1040. An allowed real estate loss reduces line 38 (AGI), line 43 (taxable income) and line 46 (income tax before penalties and credits). Assume that the real estate loss is large enough such that line 46 is zero.
Line 54 is the sum of certain credits. These credits reduce income tax but there is no impact in your situation since the income tax is already zero.
Lines 56-59 are additional taxes and penalties. Your client’s tax liability is no longer zero because of the early withdrawal penalty.
Finally, examine line 72. This entry is the sum of payments and certain other credits. These other credits are “refundable” meaning that they are treated like payments and that any excess of credit over tax is refunded.
A credit which is reported on line 72 will offset an early distribution penalty but a credit which is reported on line 54 will not.
See Pub 17 for further discussion of refundable credits.