In 1998, I began a Roth IRA and contributed annually the maximum amount allowed, however, at the end of 2003, the value of my Roth had greatly been decimated and I closed my Roth. All in all, I contributed $8,000 and its current value when I closed the Roth was roughly $5200. I had the 10% withdrawal penalty since I was younger than 59 1/2 at the time and filed my taxes as such with my tax preparer. Today I received a letter from the IRS stating that on my 2003 taxes, an omission of the $5200 was not claimed as income nor was the $520 penalty, resulting in my owing the IRS an additional $1800 (includes $94 in interest). I have a meeting with my tax preparer tomorrow but I would like anyone's input regarding my situation. I was under the impression that I could withdraw my contributions at any time tax and penalty-free and that I would only be taxed on the "earnings" portion of my Roth which I had none. To say I was caught off-guard would be an understatement. Any thoughts would be appreciated.

I am new to this roth IRA thing, and would like to add another question related to this. All the articles I've read regarding ROTh IRA says that withdrawing contributions is tax and penalty free anytime. But no one really elaborate this point. does the contribution has to be in a Roth IRA for 5 years before being elegible tax/penalty free? Since I can take out my contribution anytime without any fees, isn't ROTH IRA better than a saving account? I know there are some regulations and complications, like max of 4000/year, issue of market going down, not easy to take out money like using ATM or a check etc. but if there is no penalty, can I put my savings in a ROTH IRA and if i need it say in two or three years can i take out all my contributions out and only leave my earning in the account? if that's allowed then ROTH IRA is a very good option for everyone who's qualified, right?
I really appreciate your response. I am little hesitant right now to open a ROTH IRA because i don't have much savings and i think i may need the money that goes in IRA in the future.
thank you.

blue_indiana

Since your Roth IRA assets were from regular IRA contributions, you should not have paid the 10 % penalty, because your Roth contributions were not deductible…and for the same reason, you do not owe any taxes on the withdrawal from your Roth IRA.

Your impression of the tax treatment of withdrawals of Roth IRA contributions is correct .
Ask your tax preparer to prepare a written response to the IRS, educating them on the tax treatment of Roth IRA distributions, and include a ULR to publication 590- http://www.irs.gov/pub/irs-pdf/p590.pdf

See the article at http://www.investopedia.com/articles/retir...t/03/030403.asp for an explanation on the tax treatment of Roth IRA distributions

See http://www.investopedia.com/articles/retir...t/04/091504.asp for some basic rules.

See also IRS publication 590 at http://www.irs.gov/pub/irs-pdf/p590.pdf

"Since I can take out my contribution anytime without any fees, isn't ROTH IRA better than a saving account? I know there are some regulations and complications, like max of 4000/year, issue of market going down, not easy to take out money like using ATM or a check etc. but if there is no penalty, can I put my savings in a ROTH IRA and if i need it say in two or three years can i take out all my contributions out and only leave my earning in the account? if that's allowed then ROTH IRA is a very good option for everyone who's qualified, right?"

[COLOR=blue][B]General answer - a Roth is not a good substitute for a cash reserve in that access to money is not the same as with an ATM card, credit card or bank check. I would not use a Roth as a short term cushion. But, a Roth can be tapped without penalty to retreive all of the contributions - so in some sense it can be part of your safety net for major problems such as if you lose your job or have a severe medical problem.

I want to specifically address "better than a savings account". Roths need to be looked at as investment accounts. Savings usually mean government guarenteed principal in a transaction account that provides a very low return.... and that just won't work for building a major nest egg. Investing in a Roth means stocks, bonds and mutual funds (the stock/bond kind) and that means longer term commitments, decades not weeks or months. You don't want to have to go to your Roth when the market is down, and you don't want to raid your great tax shelter on a whim. From that perspective, you want to have a reserve that can be used to solve short term problems. Think of the Roth less as a savings account but as a long term investment that has some "safety net" potential.