Roth Conversion to avoid 10% early withdrawal penalty
Hello,
Am I correct in viewing a Roth conversion as a way to avoid a 10% early withdrawal penalty?
For instance, let’s assume I had a 40 year old with a Traditional IRA. Let’s further assume that he needs to access $10,000 of his balance, but doesn’t have another qualifying event to help him avoid a 10% penalty. Can’t we convert $10K and then have him take a distribution the next day – thereby avoiding any penalty? (I understand that he will still need to pay income taxes)
I understand the 5 year holding requirement, but doesn’t that only apply to any “earnings” in the account – not principal (or the dollar amount we converted?)
If my assumptions are correct, why would anyone do a 72(t) to avoid the penalty instead of pursuing the Roth Conversion/Distribution strategy I’ve outlined?
Am I missing something? Your thoughts are appreciated.
CFP
Scotts Valley, CA
Permalink Submitted by Alan Spross on Tue, 2010-11-30 21:01
Yes, you are missing something. There are two different 5 year holding periods for a Roth IRA:
1) The 5 year holding period along with attaining 59.5 that qualifies the Roth for fully tax free earnings distributions. This is the one you are familiar with.
2) A 5 year holding period that applies to each conversion. And the purpose for this requirement is to eliminate the strategy outlined in your post, ie doing a Roth conversion in order to get at TIRA funds without the 10% penalty. Congress figured that 5 years was enough time such that a taxpayer would be unlikely to be able to plan a conversion that far in advance of the need for funds. This 5 year holding requirement ends at 59.5, which is when all early withdrawal penalties cease.
This conversion holding period is outlined on p 64 of Pub 590.