Roth IRA Conversion 10% Penalty Trap
By Marvin Rotenberg, IRA Technical Expert
A 10% early withdrawal penalty applies to taxable funds withdrawn from a traditional IRA before the account owner attains age 59 ½ unless an exception applies. The same penalty (with its own set of exceptions) also applies on distributions made from most employer-sponsored retirement plans, unless the payment is due to the participant’s separation from service in a year in which he or she attains age 55 or older. One situation in which no penalty applies is when funds are withdrawn in order to convert to a Roth IRA (or to a Roth arrangement within a 401(k), 403(b), or 457(b)). Even though no penalty applies, the converted funds are subject to ordinary income tax to the extent they are not a return of after-tax contributions. But, two tax traps that will trip up an unsuspecting consumer can still trigger the 10% penalty.
The first trap is when funds withdrawn from the traditional IRA are used to pay the conversion tax. That’s a bad move. Funds used to pay the conversion tax are not actually converted to the Roth, so they will be subject to the 10% penalty, in addition to income tax, when the consumer is under the age of 59 ½.
The second trap occurs when funds converted to the Roth are withdrawn within the first five years and the Roth IRA owner is still under age 59 ½ and no exception applies. This means you can’t avoid the 10% penalty by first converting to a Roth IRA and then withdrawing converted funds to pay the tax.
In general, using IRA funds to pay a conversion tax is a bad idea from two perspectives: (1) less money goes into your Roth IRA to grow tax-free, and (2) paying a 10% penalty is an extremely costly tax move. Thus, it’s prudent to make sure you have sufficient non-IRA funds to pay the conversion-related income tax before considering a Roth conversion.
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