Avoiding the early distribution penalty during conversion
If an IRA participant who is under 591/2 wants to convert to Roth and reveals they want us to withhold, can we set up the conversion as follows?
i.e.
Total amount in TRA 10,000.00
Customer is under 591/2 and wants 10% withholding
Fill out 2 W/D forms
1. One for 9,000.00 not specifying withholding
2. One for 1,000.00 specifying 100% withholding
I am trying to help the IRA participant avoid the early distribution penalty because if done with one withdrawal, the withholding amount would not be considered part of the converted amount and be subject to the 10% tax. Am i making sense?
Also how is a conversion done if there is basis in the TRA?
Thanks
Permalink Submitted by Alan Spross on Sat, 2010-01-23 19:41
That will not work. Either way you are sending 1,000 to the IRS and that amount will be subject to the 10% penalty. This is one of the reasons that it is recommended that the taxpayer be able to pay the taxes from non IRA funds.
If a taxpayer has basis in traditional IRAs, the pro rated amount vrs the total balance will be tax free, so there would be no need to withhold on the tax free portion. Of course, the taxpayer can elect any withholding rate they wish, but some of this conversion would be tax free. Follow form 8606 to calculate the tax free portion of the conversion.
Another problem with tax withholding is that the taxes are lost to IRA accounts for future years. If client chooses to recharacterize the conversion, only 9,000 goes back to the TIRA and the IRS portion cannot be returned to an IRA. Taxpayer does get a credit against the final tax bill upon filing.
Permalink Submitted by Linda Randazzo on Sat, 2010-01-23 21:06
Just so i am clear,
Anyone under 591/2 doing a conversion that is requesting withholding would not be able to avoid the 10% early distribution penalty because even if two w/ds are done and both are listed as 2 seperate conversion amounts, the fact that we are sending IRS the 1,000 because of the 100% whh, this amount will be subject to the early distribution tax.
Permalink Submitted by Alan Spross on Sat, 2010-01-23 21:23
Correct. Distributions prior to 59.5 incur the penalty unless rolled over. A Roth conversion is a rollover, however the withheld amount is never a part of the conversion. It is just a distribution paid to the IRS as withholding. It would not be a separate conversion because the funds are not going into a Roth IRA, but to the IRS instead.
Permalink Submitted by Linda Randazzo on Mon, 2010-01-25 02:02
Thanks Alan,
I don’t know what i was thinking. Of course 1k is going to the IRS as WHH not to the IRA owner. I appreciate your explanation. 😕