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Mailbag Q&A: Early Distributions, Back-door Roth Conversions and More

By Sarah Brenner, JD
IRA Analyst
Follow Us on Twitter: @theslottreport

This week's Slott Report Mailbag looks into early distributions, back-door Roth conversions, and Roth IRAs. As always, we recommend you work with a competent, educated financial advisor to keep your retirement nest egg safe and secure. You can find one in your area here.

Question:

A tax payer lost his job in March. If he took an early distribution of $30,000 to live on and pay about $12,000 in medical expenses and insurance, will he be able to reduce the $3,000 tax penalty?

His AGI will be about $40,000.

Thanks,

Michael

Answer:

Hi Michael,

Usually, a distribution from a workplace plan or an IRA taken before age 59 ½ will be subject to the 10% early distribution penalty. There is no general hardship exception. However, there are exceptions for distributions used for medical expenses and for health insurance when unemployed.

If the taxpayer took an early distribution from his IRA, the 10% early distribution penalty will not apply to the amount he used to pay for health insurance while unemployed for himself, his spouse or any dependents. If the distribution came from a workplace plan, this exception would not be available.

There is also an exception to the penalty for distributions from both IRAs and workplace plans that are not more than deductible medical expenses for the year. Deductible medical expenses are those that exceed 10% of adjusted gross income. These expenses can be for the taxpayer, his spouse, or a dependent.

The details of the situation are not completely clear from your email and the rules for these exceptions can be complicated. It would be a smart move for the taxpayer to discuss the specifics with a tax or financial advisor to see if one these exceptions applies in his case.

Question:

Hi Ed. I am planning to make a nondeductible traditional IRA contribution, and then do a back-door Roth conversion this year. I have no other IRAs except for an IRA I inherited from my father several years ago. Do I need to include this IRA in the formula to determine my taxation when doing the conversion?

Thanks!

Answer:

A back-door Roth conversion can be a good strategy for individuals whose income is too high for them to be able to contribute to a Roth IRA. However, one complication with back-door Roth IRA conversions can be the pro-rata rule.

The pro-rate rule is a rule that dictates the taxation of an IRA distribution when the IRA owner has any IRA containing after-tax amounts. The rule states that, in general, an IRA distribution will consist of the same proportion of pre-tax and after-tax amounts as the IRA owner has in his or her IRA(s). This can cause problems for taxpayers who have other IRAs and are looking to do a back-door conversion. However, there is good news in your case. Inherited IRAs would not be included in the pro-rata formula. You can convert the nondeductible contribution tax-free. You will have to file Form 8606 with your tax return to account for your after-tax contribution and to tell IRS of your Roth conversion.

 

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