Roth Conversion Withdrawal Penalty

[David]

H & W both converted traditional IRAs to Roths in past years. Both had basis in a traditional IRA so the full amount of conversions weren't taxable. They both have withdrawn the Roth amounts over several years before the 5 year exclusion period. Therefore, the taxable portion at conversion amounts withdrawn should be subject to the 10% early withdrawal penalty.

The H's penalty is calculating correctly based on the amount taxable at conversion.

The W converted to a Roth in 2010 and elected to be taxed 50% in 2011 and 2012. The full amount of her Roth conversion is being treated as non taxable at conversion. I'm sure this is because she elected to be taxed in 2011 and 2012. Shouldn't the 10% penalty be assessed against the 2011 and 2012 taxable amounts? Or since she took advantage of not being taxed in the year of conversion, does she get relief from the early withdrawal penalty?

I don't see anything in the regs that indicate early withdrawal penalty relief if the taxpayer wasn't taxed in the year of conversion.

Does anyone know if the program is treating this correctly and the W isn't subject to the penalty only because she wasn't taxed at the time of conversion but was taxed in later years?

Thanks.

[Pacun]

I think the program is correct because the conversion took place in 2010. If the IRS or Congress gave you a chance to pay taxes in a delayed manner,  it doesn't change the date of the conversion.

[RitaB]

 

52 minutes ago, Pacun said:

I think the program is correct because the conversion took place in 2010.

Yes, if I understand it correctly, and we're talking about a 2015 distribution, she's met the five-tax-year period that starts with the year the conversion was distributed from the regular IRA (2010).  2010, 2011, 2012, 2013, 2014 have passed.

* I'm going to go on record as admitting that I may or may not understand it correctly, and why oh why won't people stop robbing their retirement accounts?   Leave them alone.  Please.

[mcb39]

56 minutes ago, RitaB said:

 

Yes, if I understand it correctly, and we're talking about a 2015 distribution, she's met the five-tax-year period that starts with the year the conversion was distributed from the regular IRA (2010).  2010, 2011, 2012, 2013, 2014 have passed.

* I'm going to go on record as admitting that I may or may not understand it correctly, and why oh why won't people stop robbing their retirement accounts?   Leave them alone.  Please.

Lots of that this year.  Why  oh why is right!

[David]

2 hours ago, Pacun said:

I think the program is correct because the conversion took place in 2010. If the IRS or Congress gave you a chance to pay taxes in a delayed manner,  it doesn't change the date of the conversion.

The program is treating the W's 2010 Roth conversion as 100% non taxable. She withdrew all of her Roth conversion amount in 2012. Therefore, she didn't meet the 5 year test. However, the program is not subjecting her Roth withdrawal to the 10% penalty.

So, are you saying the program is correct?

Is the reason the program is showing the 2010 Roth conversion as non taxable because she was not taxed in 2010 but was taxed 50% in 2011 and 50% in 2012? This doesn't make sense to me. I can't find anything in the regs that gives relief from the 10% penalty for TPs who chose to delay the tax for their 2010 conversion. 

The 2010 conversion wasn't taxable in 2010 and the program marked it as non taxable and carried forward the non taxable amount into future years. I'm wondering if this is an error in the program and she should be subject to the 10% penalty?

Thanks for your help.

 

 

[Pacun]

We assumed the withdrawal was in 2015 because you omitted 2012. As you know the year of withdrawal is very important in this situation. Since you omitted that information, maybe you also omitted that she was over 59.5 years old when she withdrew the money.

[Pacun]

Maybe you have also omitted that you forgot to enter her date of birth on ATX.

The program will calculate the penalty correctly if you enter her date of birth AND she was not 59.5 years old at the time of the withdrawal.

 

[David]

They both have withdrawn the Roth amounts over several years before the 5 year exclusion period. Therefore, the taxable portion at conversion amounts withdrawn should be subject to the 10% early withdrawal penalty.

My apologies. I thought when I made the comment above that it was clear the withdrawal was before the 5 year period. Neither H or W is over 59 1/2.

So based on that, do you think the program is incorrect and I should change the withdrawal amount to be subject to the 10% penalty?

Thanks. 

[RitaB]

16 minutes ago, David said:

They both have withdrawn the Roth amounts over several years before the 5 year exclusion period. Therefore, the taxable portion at conversion amounts withdrawn should be subject to the 10% early withdrawal penalty.

Are we talking about a 2015 withdrawal?  You say "several years," [after the 2010 conversion] so I assume it's NOT a 2012 withdrawal that we are discussing.  If it's a 2015 distribution of a 2010 conversion, the five year period beginning at conversion (not payment of tax - we don't care about that) has been met.  She doesn't need to be 59.5 to avoid the 10% penalty on conversion amounts.  There is not a penalty on withdrawn conversion amounts (just earnings) if the five year period has been met, regardless of her age.  Earnings would be subject to the penalty if under 59.5, yes.  I think I have that right...

As to whether the program is treating it correctly, I'd just know what is correct and spank the program till it gets there.

[David]

Both made withdrawals over several years from their 2010 Roth conversions and all before the 5 year period. I am preparing their 2012, 2013 and 2014 tax returns. Her withdrawal was in 2012. So she didn't meet the 5 year period to be exempt from the 10% penalty.

However, the program is treating it as all non taxable in 2010 and not subjecting it to the 10% penalty.

Based on what you are saying, my thoughts are correct - she should be subject to the 10% penalty and the program is wrong. Is that correct?

Thanks.

 

[RitaB]

1 minute ago, David said:

Both made withdrawals over several years from their 2010 Roth conversions and all before the 5 year period. I am preparing their 2012, 2013 and 2014 tax returns. Her withdrawal was in 2012. So she didn't meet the 5 year period to be exempt from the 10% penalty.

However, the program is treating it as all non taxable in 2010 and not subjecting it to the 10% penalty.

Based on what you are saying, my thoughts are correct - she should be subject to the 10% penalty and the program is wrong. Is that correct?

Thanks.

 

Yes, you are correct.  I really don't even know how the program would know how to handle this.  I think you'll have to dink around with it.  But, I don't know, as I've never had this situation, and I have either learned a lot today or you should ignore me completely. 

[RitaB]

David, on Form 5329, there is a worksheet for line 1.  You can enter the amount subject to penalty on the worksheet.  It'll say something like "2012 Roth distributions subject to tax on early distributions."

[David]

Rita, thanks so much for your help.

I think the program "got confused" because in the 2010 program it showed the conversion amount as non taxable since it was going to be taxed in 2011 and 2012. 

Then the program carried the non taxable designation forward each year so that when a distribution was made, it didn't apply the 10% penalty. The program should have been able to determine, by the election to tax the conversion in 2011 and 2012, that even though it wasn't taxable in 2010 it should be considered taxable for purposes of the 10% penalty.

I threw this out to the forum thinking that maybe there was an exclusion to pay the penalty for those who took that Roth conversion election in 2010 and I was not not aware of it.

Thanks again.

[Lion EA]

Aren't distributions from a Roth considered to be from the contributions first and, therefore, not taxable?  Only after the taxpayer has taken out all their contributions and is finally taking out earnings do they have taxable distributions, right?  Or does it change for converted amounts?

[RitaB]

25 minutes ago, Lion EA said:

Aren't distributions from a Roth considered to be from the contributions first and, therefore, not taxable?  Only after the taxpayer has taken out all their contributions and is finally taking out earnings do they have taxable distributions, right?  Or does it change for converted amounts?

Yes, but we are talking about the 10% penalty that applies to conversion amounts not left alone for five years or until age 59.5.  They are subject to 10% penalty to discourage people from converting traditional IRAs and then taking out the conversions penalty free.  Here's a good article:

http://www.fool.com/money/allaboutiras/allaboutiras07.htm

 

[RitaB]

18 minutes ago, RitaB said:

Yes, but we are talking about the 10% penalty that applies to conversion amounts not left alone for five years or until age 59.5.  They are subject to 10% penalty to discourage prevent people from converting traditional IRAs and then taking out the conversions penalty free. (That would be a nice loop hole, eh?)

 

 

[SaraEA]

"why oh why won't people stop robbing their retirement accounts?   Leave them alone.  Please."  PLEASE!  What do people think they are going to live on in retirement?  We've all seen it time and again.  Client takes $100k out of retirement account, then falls on the floor when we tell them how much they owe.  "But I already paid the taxes!"  Sure, you had a whole 10% withheld (which only covers the early withdrawal penalty) and NO state.  And with the added income, 85% of your SS is taxable, and your Medicare contributions will go up too.

On rare occasion a client will call BEFORE they take the distribution.  When I tell them how much to withhold/put aside for taxes and they have to keep adjusting the withdrawal amount to arrive at the cash they need to buy a home, pay bills, whatever, it does give them pause.  Yet they still do it.

Combine this common practice with the number of people who give their homes and businesses to their children so they will qualify for Title 19 someday (while their kids live in luxury) and you can see what the future holds.  There won't be enough people paying taxes to cover the nursing home costs of the purposefully destitute. Back to the days when nursing homes where people went to die.  Ten or 12 in a room with one nurse, no activities, gross food, because the taxpayers won't be able to afford it.  Repeat:  PLEASE leave your retirement accounts alone.

[JMovichEA]

How many times have you seen clients after being informed of what they owe on their retirement distribution, take out more to pay the tax, so the problem occurs over multiple years?

[Roberts]

21 hours ago, JMovichEA said:

How many times have you seen clients after being informed of what they owe on their retirement distribution, take out more to pay the tax, so the problem occurs over multiple years?

Have a client who's been doing this every year for 4-5 years. It's bizarre to watch.

I also hate it but a lot of people are switching from traditional IRAs into Roths, paying the tax and the reality is they would have avoided most or all the tax anyway if they withdrew from the trad IRA over 10-20 years. Had a 60 year old client who did this - she only had about $150k for retirement. When I told her she likely wouldn't have paid anything in tax (or very little) when she slowly withdrew in retirement she got mad at me - not the broker who did it to her.

[RitaB]

25 minutes ago, Roberts said:

Have a client who's been doing this every year for 4-5 years. It's bizarre to watch.

I also hate it but a lot of people are switching from traditional IRAs into Roths, paying the tax and the reality is they would have avoided most or all the tax anyway if they withdrew from the trad IRA over 10-20 years. Had a 60 year old client who did this - she only had about $150k for retirement. When I told her she likely wouldn't have paid anything in tax (or very little) when she slowly withdrew in retirement she got mad at me - not the broker who did it to her.

I have one who also just did this.  He didn't ask my advice, just called and asked me why the bank kept insisting he decide whether he was withdrawing or recharacterizing. 

Me:  "You are converting.  It's a conversion.  Can I run some numbers for you..."   Client:  "That's exactly right, it's a conversion.  I have read everything there is to read on this.  Thank you.  No, I've got it figured out."  Click.

OK, you probably didn't read EVERYTHING there was to read...  And using a bank for your investment broker is another thing you might reconsider...

[JohnH]

Roth conversions are highly beneficial to taxpayers who expect to be in the 15% or higher Fed bracket after retirement AND who are in the 15% bracket at the current time.  It's also very important that they be done before beginning to draw Social Security in most cases. 

There are interesting tax management strategies for someone who has sufficient income in retirement to enable them to balance regular IRA/401(k) withdrawals with Roth withdrawals to meet their living expenses with the smallest tax haircut.   Roth conversions at the right time and in the right amounts also help these taxpayers to avoid unnecessary taxes due to MRD's if they are not needed for living expenses.   But having said all that, I can only think of a few very special situations in which someone should convert ALL their qualified money to Roth.   Any financial advisor or banker who gives that sort of advice is way out of line.

[FDNY]

7 hours ago, JohnH said:

  But having said all that, I can only think of a few very special situations in which someone should convert ALL their qualified money to Roth.   Any financial advisor or banker who gives that sort of advice is way out of line.

Maybe the states should protect investors with regulation for Roth conversions like they do with annuity replacements.   While we add value to our tax prep with giving advice and suggestions, we can't be there when a broker, banker, or insurance agent calls trying to drum up business for themselves.  I've seen more than one traditional IRA converted to a Roth and put into an annuity.  One case was the clients' young broker son who sold his father an annuity (Roth conversion).  I had to explain to him what a poor financial planning move this was, it was too late.  I think he was just looking at the big commission.  Parents were not happy when they saw their tax return.   

Best advice....like Rita said, just leave it alone.  

[JohnH]

I agree. I'm usually not in favor of increased regulation, but the financial advisor industry and their bank/financial services proxies should be held to a higher standard than they are.  Any time a commission is involved, there's an incentive to give bad advice.

'It is difficult to get a man to understand something, when his salary depends on his not understanding it.' - Upton Sinclair

[SaraEA]

I have a client with multiple IRAs who has repeatedly converted some to Roths, then recharacterized (sometimes only partial), then converted again, then converted others to Roths, recharacterized, etc.  Accounts are mostly in different brokerages with different acct numbers when a conversion occurs and another new acct number when recharacterized.  Each year some of the money is not returned to any type of an IRA and is a distribution (from which type of account?)  She's done the same thing with her spouse's multiple IRAs.  I literally keep maps to track the flow, but when I she takes distributions I get lost and have no idea if the 5-year rule applies to that particular acct. Even worse, she lives in a state that does not permit tax-free contributions to retirement accounts except 401ks--and therefore IRAs if rolled over (but doesn't tax the money on the way out).  I think I have a handle on the federal taxable amts but so many of these accounts have changed character so many times I have no idea if the state amounts are correct.  I decided we'll let the state figure it out if she's ever audited.

She's doing this brilliant scheme all by herself--no advisor to blame.  When I asked why, she said something about keeping her tax rate at 15% in the future, taking out plenty of money to live on but some of it was already taxed so her rate will be low.  Guess what?  She has never been in the 15% bracket and with her pension income alone likely will never be.

I for one am thrilled with the new regs limiting conversions and recharacterizations to one per year per taxpayer, not per account!  Too late for this client though.

[jklcpa]

1 hour ago, SaraEA said:

She's doing this brilliant scheme all by herself--no advisor to blame. 

 

Perhaps she took the advice from watching Ed Slott during her local PBS fundraising campaigns.  I've heard him say to do this exact thing.