Tax free disability income to ROTH

i’m working with a client who will receive a nontaxable lump sum retirement disability distribution from our state’s department of retirement systems (DRS). According to state law, his previously tax deferred retirement contributions and credits will be paid out to him at 150% of his current balance, tax free, due to his work related disability.

The DRS says it will either give him a check for the distribution or transfer it directly to his ROTH IRA.

Would the direct transfer to the ROTH be allowed by the IRS? I was concerned whether any excess contributions penalties could be inferred under these circumstances.

Appreciate your thoughts. Thank you.



Since the original contributions were to a retirement plan, they are rollover eligible. Since they are non taxable due to disability, it makes sense to do a direct rollover to a Roth IRA. This would be considered a qualified rollover contribution under the tax code. Once in his Roth IRA, if he needs to take distributions under the Roth IRA ordering rules, these funds are treated as a non taxable conversion. That means the 5 year holding requirement for conversions does not apply for two reasons. First, he probably qualifies for a disability penalty waiver, and second only the taxable portion of a qualified rollover is subject to the penalty to begin with. This means he would have immediate access to this money without tax or penalty.



Thanks for your help.



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