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Retirement Weekly: Why am I being charged a penalty on my Roth conversion?

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Q.: In October 2020, I converted $15,000 of my IRA to my Roth IRA. My tax software says I owe a penalty of $300 because I am under 59 ½.  I knew the conversion would be taxable, so I withheld $3,000 but I thought the penalty was waived on conversions. Am I missing something?

–Terry in Flagstaff

A.: Terry, unfortunately, yes, you missed an important nuance of Roth conversions.

You are correct that when you convert to a Roth IRA, the 10% penalty for distributions from an IRA prior to age 59 ½ is not applied. The penalty arises in your case because you did not convert $15,000.

Technically, you converted $12,000 and had $3,000 withheld for taxes. Because only $12,000 of the $15,000 made it to the Roth account, the IRS considers that $3,000 to be a distribution. Taking a distribution before age 59 ½ triggers the 10% penalty. And 10% of $3,000 is $300.

Unfortunately, you cannot reverse the conversion. However, you may be able to get the penalty waived if you qualify for a “coronavirus related distribution.” This special waiver of the pre-59 ½ penalty only applies for 2020. The IRS has a FAQ page on such distributions that may be helpful. You should talk to your tax adviser about the details and appropriate documentation if you seek a waiver.

For taxpayers that are over 59 ½, the 10% penalty is not an issue, but having taxes withheld from a conversion is still not optimal. By having the taxes withheld from the conversion rather than paying the taxes with funds in a non-retirement account, a taxpayer over 59 ½ leaves the taxable account unchanged but lowers the amount that could be in the Roth.

In your case, had you paid with taxable funds, in addition to avoiding the penalty, your taxable account would have been $3,000 lower but the full $15,000 would be in the Roth, not $12,000. The additional $3,000 in the Roth could grow without tax and eventually it and the earnings on it can be removed tax free.

That may not seem like a big difference but given enough time it can be. Plus, if you convert more in the future, over time the difference can really add up.

If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide but with offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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