Inherited IRAs and the 10% Penalty, Roth Conversion Tax Highlight Mailbag

By Joe Cicchinelli, IRA Technical Expert

Follow Me on Twitter: @JoeCiccEdSlott

This week’s Slott Report Mailbag includes questions on the 10% penalty, using a portion of transferred funds to pay the tax on a Roth conversion and a controversial topic (see question #3 for that). As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

How long have they not charged a penalty when taking a distribution from an inherited IRA? My situation goes back to 1995-2000 with my mother’s IRA. The 5-year rule was the only option then. But on these tax returns I had to pay the 10% penalty on all distributions.

Thanks,

Anne

Answer:
There has never been an early distribution penalty on a distribution from an inherited IRA. It is one of the exceptions to the penalty. The 1099-R you received from the IRA custodian for the distributions in 1995-2000 should have shown a code 4 – Death in box 7. If the distributions were subject to the 10% penalty, a code of 1 – Early distribution, no known exception would be used. Unfortunately, there does not appear to be any reference to death distributions being exempt from the penalty on the current Form 1040. You also cannot request repayment of the penalty since you can only amend tax returns for the last three years and you are well beyond that time period. Hopefully your question will help others avoid a similar fate.

2.

If I can’t afford to pay the tax out of pocket on the funds I want to convert from an old 401(k) plan to a Roth IRA, is it still of benefit to use some of the transferred funds to pay the tax and absorb the penalty?

Answer:
Using money from the 401(k) plan (e.g., withholding) to pay the tax on the conversion means less money is reinvested, which means less tax-free compounding of interest. Also, if you are under age 55 and not working for that firm, a distribution from the 401(k) to pay for the taxes (i.e., the money not converted to the Roth) is taxable and subject to the 10% early distribution penalty.

Paying the taxes from money outside the 401(k) is better.

Whether the conversion is a good move for you depends on many factors and assumptions that are unique to you. Speaking with a competent advisor would be helpful.

3.

I have both pre-tax and after-tax contributions to my 401(k), and I am over age 59 ½ and currently working. Prudential, the plan administer, says that I can take just the after-tax money in the 401(k) and move it to a Roth IRA leaving the pre taxed money in the 401(k), which according to them would not produce any tax since they would provide a 1099R indicating the moving of taxed money. They said I can do this moving of only taxed money as long as I continue to work since I would have to do a total distribution once I retire. I have read the Fairmark.com article by Kaye Thomas, “Isolating 401(k) Basis for a Conversion” and this seems to contradict the paper or I may be missing something. What tax issues should I be aware of If I do this transfer/conversion to a Roth IRA? Thanks for your help.

Answer:
Separating before and after-tax funds (basis) in an employer plan is a controversial topic. Further IRS clarification is needed but has not been issued. You should discuss IRS Notice 2009-68 and the Fairmark article with your tax advisor. The custodian cannot give you tax advice. Until the IRS issues guidance, your CPA will have to determine how much of the funds moved to the Roth IRA are taxable.