Tax planning and compliance for investors
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By Kaye A. Thomas
Updated January 24, 2008
Tax treatment of amounts withdrawn from a Roth IRA after you've made a conversion from a traditional IRA.
As a general rule, you can withdraw your contributions from a Roth IRA at any time without paying tax or penalty. If you withdraw money from a conversion too soon after that event, and before age 59½, you may incur a penalty.
Subject to various exceptions, if you take a withdrawal from a traditional IRA before you reach age 59½, any part of the distribution that is taxable is also subject to a 10% penalty. Congress was concerned that taxpayers might use Roth IRAs to avoid this rule as follows:
Example: You need to take $15,000 from your traditional IRA at a time when the penalty would apply. Instead of simply taking it out, you convert that amount to a Roth IRA and pull the money out of the Roth the next day, thinking this gets you out of a $1,500 penalty.
To close this loophole, Congress imposed a special rule. If you take a distribution from the conversion money in your Roth IRA within five years after the conversion, the early distribution penalty will apply even though the distribution isn't taxable.
Example: You convert your traditional IRA, with a value of $20,000, to a Roth IRA in 2008, paying tax on the entire amount that year. In 2010, when you are under age 59½, you withdraw $5,000 from the Roth IRA, and the distribution comes from conversion money because you haven't made any regular contributions to your Roth IRA. The distribution isn't taxable because you already paid tax on that amount in 2008. You owe a $500 early distribution penalty, though, (10% of $5,000) unless you qualify for one of the exceptions (such as disability or medical expenses).
More precisely, this rule will apply if your withdrawal occurs before the first day of the fifth taxable year after the year of the rollover. The year of the rollover is considered to be the year the money came out of the traditional IRA, not the year it went into the Roth IRA, if those are different years.
The first distributions you take from any Roth IRA are considered to come from regular contributions you've made to Roth IRAs, even if you made them to a different Roth IRA. After that, before you withdraw any earnings, your distributions come from conversions. If you've made more than one conversion, money from the earliest conversions will come out first.
There's a further refinement. You may have a conversion that's only partly taxable because you made nondeductible contributions to a traditional IRA before the conversion. In this case, when you start to withdraw money from that conversion, the taxable dollars come out first.
Example: You have a traditional IRA with a balance of $10,000, which includes $4,000 of nondeductible contributions. During 2008 you convert this IRA to a Roth IRA, paying tax on $6,000. During 2010 you make a regular contribution of $2,000 to a different Roth IRA. During 2011 you withdraw $3,000 from the conversion Roth IRA.
Result? The first $2,000 of the withdrawal is considered to come from your regular contribution — even though you're withdrawing money from a different IRA, and even though you contributed that money in a later year. The order of your contributions doesn't matter until we come to the conversion money.
The remaining $1,000 is considered to come entirely from the taxable part of the conversion, so the 10% penalty will apply to that entire amount. You can't treat that distribution as being 60% taxable and 40% nontaxable. If you withdraw more than $6,000 of your conversion money within five years after the conversion, only the first $6,000 will be subject to the 10% penalty because the remaining portion was nontaxable at the time of the rollover.
This penalty only applies in the year of the conversion and the following four taxable years. For example, if you made a conversion in 2008, the penalty won't apply to any distribution on or after January 1, 2013. Also, the penalty doesn't apply if you are over age 59½, or if you can fit within any of the exceptions to the early distribution penalty.
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