Roth IRA Conversion Penalty

Is there a Roth IRA conversion penalty?

If you're thinking of converting a Traditional IRA to a Roth IRA, you need to know. The last thing you want is a surprise tax bill from the IRS...

So is there a conversion penalty?

The short answer... No.

Additional penalties are NOT levied against you for converting a Traditional IRA or similar retirement account to a Roth IRA.

But...

While there isn't a literal Roth IRA conversion penalty, you run the risk of several expensive pitfalls (which substitute as de facto penalties) if you don't take the time to learn the applicable tax rules.

So learn the tax rules!

Because knowing the rules can save you a lot of money and a lot of headaches...

There Is No Roth IRA Conversion Penalty, But...

While there's no specific Roth IRA conversion penalty, you do owe income taxes on most converted funds from a Traditional IRA.

Why?

Because most contributions to a Traditional IRA are tax deductible (meaning you pay with pre-tax dollars), you need to pay income tax on those funds when you make a conversion. Otherwise, you could fund your Traditional IRA with pre-tax dollars, convert to a Roth IRA, and withdraw funds tax-free in retirement. The IRS isn't too keen on this idea, because they want a piece of the pie. So somewhere along the way, you're going to owe income taxes...

Need an example?

Let's say you funded your entire Traditional IRA with tax deductible dollars.

Your Traditional IRA has a balance of $150,000. You decide to convert the Traditional IRA to a Roth IRA because you don't want to pay taxes upon withdrawal in retirement...

So, how is the conversion treated?

It's treated just like regular taxable income in the same tax year in which you make the conversion.

So if you make your Roth conversion in 2010, the $150,000 in your Traditional IRA is added to your 2010 income and taxed accordingly.

Let's say you have an income tax rate of 40%. In this case, you owe $60,000 in income taxes as a result of converting your Traditional IRA to a Roth IRA.

You now have a Roth IRA with $90,000. You owe zero additional taxes, and your conversion is NOT subject to a 10% early withdrawal penalty.

Does that make sense?

Whether it makes sense or not, it's always a good idea to seek the help of a financial professional when dealing with large sums of money and IRA conversions.

Why?

That extra set of eyes might catch something you didn't notice, and that something might save you thousands of dollars as well as provide you with peace of mind. And peace of mind is priceless.

What are some of the details you might overlook?

Well, let's say you make non-tax deductible contributions to your Traditional IRA. This is somewhat unusual, because most people make tax deductible contributions to a Traditional IRA, and those contributions are then subject to income tax during a Roth conversion.

But non-tax deductible contributions are NOT subject to income tax...

Why?

Because you already paid income taxes on those contributions BEFORE you funded your Traditional IRA, just as you would have done prior to funding your Roth IRA.

Overlooking this fact might cause you to overpay the income taxes due on your Roth conversion. And you don't want to overpay your taxes, do you?

Another notable fact?

All your Traditional IRAs are treated like one IRA...

What does that mean?

It means that in the eyes of the IRS, you only have one Traditional IRA, even though you may have funds in multiple accounts.

For example, let's say you open and fund a Traditional IRA with non-tax deductible dollars early in your career. After you get married, you stop funding this account and forget about it.

Later on in your career, you meet with a financial advisor and open up another Traditional IRA, funding it with tax deductible contributions.

In this case, you have two accounts... One with tax deductible contributions and the other with non-tax deductible contributions.

So it makes sense to convert the Traditional IRA account that was funded with non-tax deductible contributions to a Roth IRA... Right?

That way, the non-tax deductible contributions won't be subject to income taxes during the conversion. There's no Roth IRA conversion penalty, and you save money... Right?

Wrong!

Even though you have accounts at separate financial institutions, the IRS views them as one.

So, in this instance, if you did covert the account with non-tax deductible contributions, you still owe income taxes.

Why?

Because the IRS calculates the amount of income tax you owe based on the total percentage of tax deductible versus non-tax deductible contributions you made. So, in this case, the IRS treats a percentage of your non-tax deductible contributions as tax deductible, increasing your income tax liability.

Confused?

I don't blame you. That's why I highly recommend visiting a tax professional before undertaking a Roth conversion.

But the tax rules aren't all you have to worry about with a Roth IRA conversion. If you aren't careful, you might trigger a few somewhat more traditional Roth IRA penalties and taxable distributions...

Age 59 ½ and The Early Withdrawal Penalty

Another back door Roth IRA conversion penalty to look out for occurs at age 59 ½.

Under most circumstances, you can't withdraw funds from a Traditional IRA or a Roth IRA prior to age 59 ½ without incurring a 10% early withdrawal penalty.

But a special exception is made if you convert a Traditional IRA to a Roth IRA. As a result, you won't pay a penalty on your conversion even if you're under age 59 ½.

However, even though you avoid the 10% early withdrawal penalty, you still owe income taxes on the conversion funds.

And, if you then try to withdraw investment gains from your Roth IRA prior to age 59 ½ (even though you just paid income taxes), you might trigger the 10% early withdrawal penalty after all.

So be careful. With very few exceptions, tax-free and penalty-free withdrawals from a Roth IRA are reserved for those 59 ½ years old or older who have opened and funded their Roth IRA for at least five tax years.

So while a Roth IRA conversion temporarily waives the early withdrawal penalty, it doesn't permanently exempt you from all taxes or penalties related to Roth IRA distributions. (In other words, a de facto Roth IRA conversion penalty.)

The 5 Year Holding Period and Early Withdrawal

Another common pitfall of conversions (and thus, a sort of Roth IRA conversion penalty) is the 5 year rule.

What's the 5 year rule?

It's a Roth IRA rule which states that distributions are only qualified (tax-free and penalty-free) after the account is open and funded for at least five tax years. This rule applies even If you're over age 59 ½.

So don't assume that your Roth IRA conversion is in the clear because you're 60 years old. You still have to meet the 5 year rule before your Roth IRA distributions are tax-free and penalty-free.

Need an example?

Let's say you open and fund a Traditional IRA at age 20.

At age 58, your financial advisor tells you it makes sense to convert your Traditional IRA to a Roth IRA. So, you do it. You pay the applicable income taxes, and everything works out perfect. You now have a Roth IRA.

So at age 61, you go to withdraw some of your Roth IRA investment gains... Can you do so tax-free and penalty-free?

No.

Why not?

Because your Roth IRA needs to meet the 5 year holding period first.

When you converted your Traditional IRA to a Roth IRA, the 5 year tax clock started ticking. Let's say you made the conversion in the 2008 tax year...

Under IRS rules, five tax years need to pass before you can withdraw Roth IRA investment gains tax-free and penalty-free. The clock begins in January of the conversion tax year.

So 2008... 2009... 2010... 2011... and 2012 makes five tax years.

In this instance, you won't be able to take a tax-free, penalty-free Roth IRA distribution until January 2013, even though at age 63 you've been well above the minimum age of 59 ½ for some time.

Do you see how a failure to understand the rules might result in a sort of "back door" Roth IRA conversion penalty?

Conclusion

While there is no implicit Roth IRA conversion penalty, you need to be aware of the tax and distribution rules governing IRAs. Otherwise, you might accidentally trigger a penalty or tax liability which is, in effect, a Roth IRA conversion penalty...

My advice?

Always consult a financial professional when performing a Roth IRA conversion. While you have the financial intelligence, competence, and ability to perform the conversion yourself, there's just too much to be overlooked. And you don't want your conversion to cost anymore than necessary.

A second opinion goes a long way in providing you with the peace of mind necessary to enjoy life, knowing your financial affairs are in good order.