Tax on IRA withdrawal for home purchase

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Dear Tax Talk,
I e-filed my 2010 personal tax return with a popular tax preparer company. It was for the same year I purchased my first home, so I used my IRA — $10,000.

Last month, I received a letter from the IRS wanting me to pay $2,750 in taxes on the $10,000 IRA withdrawal. I wrote back and provided all my documents. Now the IRS just sent me back a new bill in the amount of $1,750. Do I correct my 2010 tax return to avoid the tax and penalty? Please help! Thanks.
— Liz

Dear Liz,
The first thing you need to understand is that if only tax-deductible contributions were made to your IRA account, then the distributions are all fully taxable. However, if you made nondeductible contributions or rolled over any “after tax” amounts to your IRA, then these amounts are not taxable to you when they are distributed to you.

Now for the second part: Taxable distributions made before you are age 59 1/2 are subject to an additional 10 percent tax unless you meet one of several exceptions. In your case, you do not have to pay the additional tax on the $10,000 if you use the distribution to buy, build or rebuild a first home. According to the IRS, generally, you are a first-time homebuyer if you had no present interest in a main home during the two-year period ending on the date of acquisition of the home for which the distribution is being used to buy, build or rebuild.

So it appears that the IRS has removed the 10 percent additional tax of $1,000 on the $10,000 distribution and revised your bill accordingly to tax you only on the $10,000 IRA withdrawal. If it turns out that some of the distributions are not taxable to you, then you will need to write the IRS and provide them with additional information so they can adjust the amount that you owe.

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