10% Penalty Applied to Roth Conversion? Maybe

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In general, when you withdraw funds from an IRA prior to age 59½, your withdrawal is subject to both income tax and the 10% early withdrawal penalty. The 10% penalty is waived if your withdrawal is for one of the exception categories, including first-time home purchase, certain medical expenses, and the like. For a complete list of the exceptions, see the article I had previously written which provides links to the various exceptions to the 10% penalty.

One of the exceptions to the penalty is a withdrawal for a Roth Conversion. You still must pay ordinary income tax on the conversion, but generally the 10% penalty will not apply to amounts converted from a traditional IRA to a Roth IRA.

However (and there’s always a however in life), there are a couple of situations where the 10% penalty could impact you as you enact your Roth Conversion.

Funds used to pay the tax

If you used some of the funds from your Roth Conversion to pay the tax on the conversion, then effectively those funds were not converted. Therefore, if you’re under age 59½, the 10% penalty will apply to those funds that you used to pay the tax on the conversion.

For example, if you withdrew $50,000 from your traditional IRA to convert to a Roth IRA, but pulled out $5,000 to pay the tax on the conversion, then you really only converted $45,000 into the Roth IRA – and the $5,000 was withdrawn for other purposes than the conversion – so therefore subject to the 10% penalty. The entire $50,000 withdrawn from the traditional IRA would also be subject to ordinary income tax, as you might expect.

Funds withdrawn within the first five years

When you convert funds from a traditional IRA to a Roth IRA and you’re under age 59½, the converted funds are restricted from withdrawal for the lesser of five years or until you reach age 59½. If you withdraw the converted funds from the Roth IRA prior to the date the restriction is lifted, your withdrawal will be subject to the 10% penalty.

This restriction is in place to keep a taxpayer from converting funds to a Roth IRA prior to age 59½ (avoiding the 10% penalty) and then immediately withdrawing the funds from the Roth IRA account, thereby effectively taking a withdrawal from the traditional IRA without penalty. By requiring a delay for such withdrawals of up to five years, this strategy will lose its luster for someone who is hoping to use it to his advantage.

It does provide a way for an individual to do some advance planning if he or she chose to do so, though…

Advance Planning Strategy

Imagine if you were age 50 and hoped to retire in five years. You have a traditional IRA, amounting to $250,000, plus a pension and a 401(k) plan at your employer. You know that you’ll need $50,000 per year to live on during the years of age 55 to 60 – so you could convert $50,000 per year for the next five years, paying the tax from other sources.

Then you would have $50,000 per year available to you, beginning at age 55, that would be totally free from tax and penalty, since the conversion occurred more than five years in the past. When you reach age 60 you’ll have unencumbered access to your other sources of income (since you’re over age 59½), and in a few years you’ll have Social Security available as well.

It’s not a strategy that will work for everyone, but in certain circumstances it might work well for you.

NOTE: You’d want to plan this out very carefully so that you don’t trip up on any of the conversion dates and your future withdrawal dates.