If you had a rough year running your business, you may have to take a distribution from your individual retirement arrangement to make ends meet. If you're under 59 1/2 years old, the taxable portion of the distribution will be subject to an extra 10 percent tax penalty unless an exception applies. Though it won't eliminate any tax consequences, your business losses can help reduce your tax burden.
Offsetting IRA Income
Taxable income from an early distribution is treated the same way as other income, such as wages or salary, that can be offset by business losses. For example, if you have a $10,000 taxable early IRA distribution and your business has a $10,000 loss for the year, you must report the $10,000 of income from the IRA distribution, but it will be offset by the $10,000 loss so you'll have an adjusted gross income of $0.
Offset Not Always Needed
If you take an early Roth IRA withdrawal, your distribution might not be taxable in the first place. With a Roth IRA, you're allowed to take out your contributions tax-free and penalty-free at any time. However, once you start taking out earnings, then the earnings count as taxable income and are subject to the 10 percent additional tax on early distributions. As a result, if your early Roth IRA distribution consists of only contributions, you won't have any taxable income for the business loss to offset.
No Penalty Offset
You cannot use your business losses to offset an IRA distribution when it comes to the early withdrawal penalty. The penalty is calculated separately from income taxes, and that IRS does not allow a business loss to qualify for an exemption from the penalty. For example, if you have a $10,000 taxable early IRA distribution and a $10,000 business loss, you still owe the $1,000 early withdrawal penalty.
Tax Reporting of Penalties
Even if you wouldn't otherwise have to file an income tax return because your income is too low, you must file a tax return if you owe the early withdrawal penalty for an IRA distribution. For example, if the income filing threshold for your filing status if $15,000 and your only income is a $10,000 early IRA distribution, even if you can offset the entire distribution with a $10,000 business loss, you have to file a tax return because of the early withdrawal penalty. You figure the penalty with Form 5329 and then report it on line 58 of Form 1040.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."