Do I owe taxes on early IRA withdrawal from account funded with after tax dollars?

I had a traditional IRA account and in 2009 I withdrew my funds to pay debts. At that time I had about $4000 in the account and had lost any small amount I had gained over the previous 2 years (about $600). The IRS has billed me $1600 in taxes and penaltieson this money. I was under the impression that since the account was funded with after tax money (and I took a loss), I would not owe any taxes on the early withdrawal.  If this is so, how do I prove to the IRS I do not owe the money?

If I do owe the money, how come my money is taxed twice?
  • Someone else with more IRA experience can provide more of an answer, but I need to at least start with the basics of a traditional IRA account.  Yes, that account is typically funded with after tax dollars.  However, with a traditional IRA, you are supposed to report the amounts you put into the account every tax year and take a deduction from your taxes.  The IRS assumes that you have reported the money that you put into that traditional IRA account as a deduction on your prior year's taxes and reduced your taxable income for those tax years.

    The basic idea of a traditional IRA is to reduce taxes at your current level of taxation with the money set aside for later.  Then, when you withdraw the account funds at a later date (ideally at retirement), your tax bracket is lower and you benefit from lower tax on your IRA savings account distribution amounts.

    In most cases, when you withdraw from your traditional IRA account prior to age 59 1/2, then that money is taxed at an even higher rate because it is considered an early distribution by the IRS and is subject to an additional 10% early distribution penalty as well as being included as income subject to your regular tax rate.  There are some allowed exceptions for the early distribution penalty, but not many.

    A Roth IRA account is the usual type of IRA that is funded with what you use as "after tax" money; a Roth IRA is reported, but not taken as a deduction from your income in the year that you invest the money in the account.  Roth IRA account distributions are taxed differently because the original amounts invested were already taxed.
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In any year that you make non-deductible contributions to a traditional IRA, you are required to report that amount on Form 8606. That establishes your cost basis in the IRA. In the year that you make a withdrawal from a traditional IRA, the distribution is reported to you on a Form 1099-R. You report the distribution on your tax return and calculate the taxable part, if any, on Form 8606 that is filed with your tax return for that year. Form 8606 is also used to determine the amount of the withdrawal, if any, that is subject to the early withdrawal penalty. If the cost basis is more than the withdrawal amount, then the taxable amount is zero and there is no penalty.

The IRS gets a copy of the 1099-R that reported the distribution to you. If you did not report the distribution on your tax return and establish the taxable amount by including Form 8606, then when the IRS compares the 1099-Rs they have against those reported on your tax return, they will assume that the distribution is all taxable and impose the 10% penalty for early withdrawal.

The IRS notice that you got told you what to do if you disagree with the notice. You can contact them at the number that they provided you and ask what they need as proof of non-taxability. If you filed Forms 8606 as required, then it should be a simple matter to show the IRS copies.

You can find the reporting requirements for traditional IRAs in IRS Publication 590, at this link:
http://www.irs.gov/pub/irs-pdf/p590.pdf
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