Roth IRA rules are complicated. One especially complex area is understanding Roth conversions and the 10% penalty. Here are five things you need to know.
1. 10% Penalty and Roth IRA Conversions
The 10% early distribution penalty doesn’t apply to a Roth IRA conversion. This is good news for those under age 59 ½. While funds you convert to a Roth IRA are taxable no matter your age, the 10% penalty doesn’t apply to conversions. Be careful here. Withholding funds to pay taxes on the conversion results in a 10% penalty to the amount withheld. (Any amount not converted is a regular distribution. This includes the portion you used to pay taxes.)
2. Withdrawing Converted Amounts When Younger Than 59½
For those younger than 59½, the 10% penalty applies when you withdraw converted amounts that were taxable within five years of the conversion. A distribution made more than five years after the conversion isn’t subject to the penalty. The five-year holding period doesn’t apply to people over age 59 ½. (So, for those 65 or older who convert, your funds are immediately available without tax or penalty.)
3. The 10% Penalty Doesn’t Apply to Basis
After-tax amounts converted from a traditional IRA or company plan to a Roth IRA aren’t subject to the 10% early distribution penalty. Called “basis”, the 10% penalty doesn’t ever apply to those funds. In our example, “after-tax” is just that; money deposited into a traditional IRA or 401K with after tax money.
4. Different Five-Year Periods
The five-year period applies separately to each Roth conversion made in a separate year. This can be confusing! This is because there are different five-year holding periods when it comes to Roth IRA distributions. The five-year period for qualified earnings begins with the first contribution to any Roth IRA. When it comes to the 10% penalty on distributions of converted funds, the rules work differently. Each Roth conversion you do will have its own five-year period.
5. Exceptions Are The Same
Exceptions early distributions from traditional IRAs are the same as distributions of converted funds within five years (if you’re less than 59 ½.) For example, if you’re 46 and converted two years ago, then take a distribution from your converted Roth IRA to pay your daughter’s college tuition bill, the 10% penalty doesn’t apply.
Consult a professional prior to acting on any recommendations and verify what any tax implications will be and