early distributions from a Roth – taxed as capital gain or ?
Suppose someone is under 59.5. 1) they have not met the 5 year mark for the roth conversion. They have already taken out their contribution and there is a gain. Of course they will face a 10% penalty on the gain, but is the remainder of the gain taxed at ordinary income tax rates or capital gain rates?
2) same scenario except they have met the 5 year mark for the roth conversion. Still under 59.5 so would they only be subject to the 10% penalty tax (assuming they don’t meet one of the exemptions)?
Permalink Submitted by Alan Spross on Tue, 2010-12-07 22:50
Q 1) No type of IRA distribution is ever taxed using cap gain rates. All IRA distributions are taxed as ordinary income other than amounts considered to be basis due to non deductible contributions.
Therefore, in your question, the amount representing gains would be taxable at the ordinary income rate plus the 10% penalty.
Q2) If under 59.5, distributions are not qualified. For Roth conversions, the 5 year holding period you refer to only applies to the early withdrawal penalty. So in this casem the withdrawal of the converted amount would tax free and penalty free, but withdrawal of earnings would still be subject to tax and penalty.
Remember, there are two different 5 year holding requirements for a Roth IRA:
1) For each conversion to avoid the 10% early distribution penalty only
2) For all IRA distributions, a 5 year holding period measured from the first year of any Roth contribution. When this is achieved ALONG WITH reaching 59.5, the Roth is qualified and all distributions are tax and penalty free, whethe from contributions or earnings.
Both your questions relate only to the conversion holding period shown in 1) above.