early roth distribution
I am converting my traditional IRA to a Roth IRA on Jan 1, 2010. After paying the taxes on the conversion I will have $100,000 left to put into my Roth IRA. I would like to withdraw $10,000 every year from the Roth IRA for living expenses. These distributions are early distributions within the 5 year holding period. Assuming that I make 5% earnings ($5,000 each year) on the Roth IRA, will I be taxed or incur a 10% penalty on my $10,000 distribution during the 5 year maturation or holding period? I am told that if I designate the $10,000 as coming from the principal that was converted from the traditional IRA and not from the earnings, that I will not have to pay tax or penalty on the distribution.
Is this correct?
Permalink Submitted by Alan Spross on Tue, 2009-09-01 02:58
No, there are a number of errors in this plan, including the apparent intention of paying the conversion taxes out of the IRA distribution. Do you have any other Roth IRA balances at this time, and what is your age? Do you expect to need 10,000 from the Roth each year indefinitely for living expenses?
Permalink Submitted by DEAN KRAMER on Tue, 2009-09-01 17:41
Thanks for your response. I don’t have any other assets to pay the tax, so I have to take it from the assets in the traditional IRA. I know that is not ideal or recommended but I have to do it to convert to the Roth. I must generate $10,000 a year for financial obligations so I am committed to taking an early distribution from the Roth during the 5 year holding period. My question is whether that $10,000 distribution is going to be subject to tax or penalty. I have received diversive opinions. I have a CPA who says that money taken in the 5 year period will be subject to a 10% penalty and a financial planner who says I can take the $10,000 without any tax or penalty. I’m confused. . . .
Permalink Submitted by DEAN KRAMER on Tue, 2009-09-01 17:47
My age is 71. I will need to take the $10,000 from the Roth as long as the money in the Roth lasts. I only have a single IRA (my traditional IRA). The value of the traditional IRA has grown over the last 25 years from rolling over funds from prior pension plans and defined benefit plans. The vlaue of the traditional IRA is about $150,000. My tax bracket is 35% so after paying the 35% on the $150,000 I will net about $100,000 to go into the converted Roth IRA. Hope this additional information is helpful. Thanks again.
Permalink Submitted by Alan Spross on Tue, 2009-09-01 18:13
Since you are over 59.5, you will never have to pay any 10% early distribution penalty, no matter what you do. You can convert to a Roth IRA and take funds out the next day if you wish without tax or penalty.
One complication here is that conversions done in 2010 are not reported until 2011 and 2012 unless you elect to report the entire conversion in 2010. This applies to 2010 conversions only, not to those done later. But when you withdraw those conversions prior to 2012, the tax is accelerated to the year of distribution.
For example, if you convert 100,000, you would normally report 50,000 each in 2011 and 2012. But if you withdraw 10,000 in 2010 and 2011, you will have to report 70,000 in 2011 and 30,000 in 2012 instead. The decision is further complicated because your 35% bracket rate will probably increase in 2011 and 2012. If you are more concerned about higher tax rates, you could elect to report the entire conversion in 2010 instead. This decision does not have to be made until Oct 17, 2011, so you can keep your options open to see what actually happens with 2011 tax rates, and you will also know your 2010 tax bill and alot about your 2011 tax bill as well by that date.
If you opt for the two year deferral, you could convert the entire 150,000, and then begin to take distributions as your quarterly estimated taxes are due in 2011, since you would not owe extra taxes in 2010. But if you opt to report the entire conversion in 2010 instead, you will face underpayment penalties for your 2010 taxes. Putting this all together is very complex, and should also consider your entire tax picture. RMDs also come into play here, although there is no RMD for 2009. In 2010, any year end balance in your TIRA as of 12/31/09 will generate an RMD. In 2010, you must take your RMD FIRST, before doing any conversion, and can then convert additional amounts. Your RMD may be around 6,000, so you would have to take out the 6,000, and then convert all or additional amounts the next day.
Back to you opening post, your financial planner was correct and the CPA was wrong – or thought you were under 59.5!