Not paying the 10% early distribution penalty
Can someone please let me know if this strategy works?
John is 35 years old has a traditional IRA at fidelity. He would like to not have to pay the 10% early distribution penalty so he does the following:
John converts his traditional IRA into a ROTH IRA. He pays for the conversion taxes with other outside funds. John has the money invested in a money market account and there have been no gains in the contract. 2 weeks later John requests a lump sum distribution. Will John have to pay the 10% penalty?
I know that with a Roth IRA you have to have the account established for at least 5 years and have to be over the age of 59.5 to be able to take any of the gains tax and penalty free, but in this scenario, John has the money in money market so there will be no gains in the contract.
John is not interested in a 72(t) distribution as he wants the money now.
Permalink Submitted by Alan Spross on Thu, 2012-11-15 00:50
Yes, generally he will owe the penalty.
There will be a 10% penalty on the taxable portion of the conversion if the funds are distributed in the first 5 years. Since this is just another form of early distribution penalty, the penalty ceases for distributions after age 59.5 just like other early distribution penalties would. If taxpayer has basis in his TIRA when he converts, the penalty would not apply to the non taxable portion of the conversion funds.
The purpose of this rule is to prevent what appears to be the intent in this case. That is, a Roth conversion cannot be used to get around the penalty for a TIRA distribution when the taxpayer wants access to the funds. 5 years was determined to be the end of the Roth conversion holding period, probably because very few taxpayers could plan on needing funds that far into the future when they did the conversion.
Of course, there are several other penalty exceptions that could waive this penalty. They are the same ones that would have waived the penalty on a simple TIRA distribution eg disability, higher education expenses, first home purchase, high medical expenses or health insurance if unemployed.
Permalink Submitted by Casey Herron on Thu, 2012-11-15 01:35
I thought the 5 year window was only if there were gains above your conversion basis then you would have to pay the 10% penalty on any of the gains. What you’re saying doesn’t sound like it is the case though. Thanks for the reply.
Permalink Submitted by Alan Spross on Thu, 2012-11-15 01:51
There are two different 5 year holding periods for a Roth IRA:
1) For the Roth to become qualified (along with reaching 59.5) – this is when the earnings become tax and penalty free
2) For individual conversions to be held before a 10% early withdrawal penalty ends
You were thinking of the first one above, but in this case it is the second one that applies.