Early distribution from Roth after conversion

Question of the Week: If a client makes a Roth IRA conversion contribution and then closes the account, what are the tax impacts of the early distribution?

February 19, 2020

Q: If a client makes a Roth IRA conversion contribution then closes the account, what are the tax impacts of the early distribution?

A client converted $5,000 from her traditional IRA to a new Roth IRA in 2018. She had no basis in the IRA so the conversion was fully taxable. In 2019 she withdrew the entire balance, about $5,200, and closed the account. Is the distribution partly taxable? Is it subject to a penalty? She is 45 years old.

A: The Roth distribution is partly taxable and subject to the 10% additional tax on early distributions.

Your client’s Roth IRA distribution is not a qualified distribution. It is partly taxable, and the entire distribution is subject to the 10% additional tax (penalty) on early distributions.

Qualified and nonqualified Roth IRA distributions

A qualified distribution from a Roth IRA meets both of the following rules:

  1. Made after the five-year period beginning with the first day of the year of the contribution, and
  2. Made on or after the date the taxpayer reaches age 59½, or made because the taxpayer is disabled, or paid to a beneficiary or estate after the taxpayer’s death, or eligible for the first-time homebuyer exception.

It appears your client opened a new IRA and its first and only contribution was her conversion contribution. The five-year period thus began on January 1, 2018, i.e. the first day of the year in which she made the conversion. Since the distribution was made before January 1, 2023, it is a nonqualified distribution. Note that even if one of the second requirements applied, such as reaching age 59½, it would still be a nonqualified distribution because of the five-year requirement.

Earnings subject to income tax

Under the Roth IRA ordering rules, distributions are considered distributed from:

  • Regular contributions, then
  • Conversion and rollover contributions, then
  • Earnings

In this situation, your client distributed the entire balance in her Roth IRA which consisted of the conversion contribution and earnings. She paid tax on the converted amount in 2018 so it is not taxed again on distribution. However, because this is a nonqualified distribution, the $200 earnings are taxable.

Entire distribution subject to 10% additional tax on early distributions

The 10% early distribution penalty applies to the entire distribution – both the converted amount and the earnings – unless an exception applies. Put another way, here, the penalty applies as if your client had not made the Roth IRA conversion to begin with. The purpose of the five-year rule is to prevent taxpayers who would otherwise be subject to the early distribution penalty from converting traditional IRA amounts to a Roth and then quickly withdrawing the amounts.

You might ask your client why she withdrew the funds. It’s possible the first-time home buyer, or education, or medical exception to the 10% penalty applies. (If it applies, the first-time home buyer exception would not make this a qualified distribution, as explained above, but would avoid the 10% penalty.)

Originally published in the February 19, 2020 edition of TAX in the News.

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