Q. Last week you mentioned withdrawals from IRAs. It’s my understanding that the rules are different for Roth IRAs. Is it true that I can contribute or convert to a Roth IRA and then take the money back out without taxes or penalty? I’m under 59 ½ and am thinking I could convert part of my IRA to a Roth IRA and therefore avoid the 10 percent penalty when I withdraw funds. I could also avoid most of the taxes by converting my one IRA that contains all nondeductible contributions, so I’d only owe tax on the earnings amount.
A. You have some of the facts concerning withdrawals from Roth IRAs correct but you are missing some facts that could trip you up. The main ones are the pro rata rule and the five-year rule on conversions. When you convert a traditional IRA to a Roth IRA you owe taxes on the tax-deductible contribution amount and any earnings. If the IRA converted or any other IRA you own contains nondeductible contributions, the pro rata rules apply. You can’t cherry pick and only convert the nondeductible IRA. You must take the total of all of your IRAs and determine the nondeductible percentage of the total amount. Example: The total of all IRAs owned is $20,000, of which $5,000 is from nondeductible contributions. You convert $5,000 to a Roth IRA. The nondeductible contribution amount was 25 percent of your total IRA value, so only 25 percent of the $5,000 you convert will not be subject to tax. You will owe federal and state income tax on $3,750. You now have a $5,000 Roth IRA from a conversion not a contribution.
The 10 percent early withdrawal penalty rules are different for Roth IRA conversions and contributory Roth IRAs. Annual contributions may be taken any time for any purpose free of income taxes and penalty. Any earnings are still subject to taxes and the 10 percent early withdrawal penalty if taken prior to age 59 ½ unless one of the following exceptions are met: IRA owner meets the IRS definition of disability, death, taken in a series of substantially equal periodic payments, are used to pay for unreimbursed medical expenses, used to pay for medical expenses after receiving unemployment compensation, used for a first-time home purchase, used to pay for qualified higher education expenses or used to pay back taxes. The details of these exceptions can be complex. Make sure you understand all of the requirements before you make any withdrawals.
The early withdrawal penalty will apply to a distribution from a Roth IRA holding conversion money if the distribution is made within the five-tax-year period starting with the year that the conversion occurs, unless one of the above exceptions apply. Example: Convert $20,000 from a deductible IRA to a Roth IRA in 2013. In 2019 you can take a $20,000 distribution without the early withdrawal penalty or any income tax even if you are under age 59 ½ and do not meet any of the exceptions. If you took a distribution in a year prior to 2019, the 10 percent penalty would apply because you didn’t keep the conversion money in the Roth IRA for the required five-tax-year period.
The rules can be complicated, especially if you have Roth IRAs consisting of money from both contributions and conversions made in different years and earnings on both. If you need to make a withdrawal prior to age 59 ½ a consultation with a knowledgeable tax or financial professional is advised.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624