The Roth Conversion Penalty You Didn’t See Coming

Numerous individuals find the prospect of transferring their assets from a conventional IRA or 401(k) plan to a Roth individual retirement account appealing due to the tax-free income it provides during retirement, as well as the tax-free distributions that become available once they reach the age of 59 and a half.

While converting traditional retirement accounts to a Roth IRA is not a bad idea, it can have unexpected consequences if you are not 59½. The confusion arises when taxes are withheld during a Roth conversion for individuals below 59½ years old. When an individual undertakes a Roth conversion, that action becomes subject to taxation and is irreversible and final. Once the bell has been rung, it cannot be unrung. The deed is done; it’s final.

Although the details of the pro-rata rule and the extent of taxable conversion can be debated, they aren’t the focus here. Let’s assume no after-tax funds are involved; this is purely a 100% taxable affair.
It is best to settle the tax obligation using non-qualified assets, such as funds from your checking account. By preserving the entire conversion amount for the Roth IRA, it can grow tax-free and prevent unpleasant surprises. However, not everyone has extra money lying around to pay for the conversion tax.

Many opt to utilize funds from the IRA, either entirely or partially, for tax withholding. For instance, the full amount is taxable if a $100,000 conversion is conducted. Opting for a 20% tax withholding means only $80,000 finds its way into the Roth IRA. When tax season arrives, $20,000 has already been dispatched to the IRS. Paying the taxes upon conversion can reduce the tax impact when April arrives.

On its own, this practice of converting 401(k) and simple IRAs to a Roth IRA isn’t problematic. The issue arises when taxes are withheld during a Roth conversion for individuals younger than 59½. What’s the snag? Taxes withheld during a Roth conversion aren’t converted. The withheld funds represent a standard early withdrawal remitted to the IRS. For those under 59½, such early withdrawals incur a 10% penalty (unless another exemption is applicable).

An example would be 35 years old with a traditional IRA worth $100,000. The 35-year-old opts to convert his IRA to a Roth IRA. Due to a lack of available cash, the 35-year-old opts to have taxes withheld from the IRA during the conversion. The full $100,000 amount will be transferred, with $20,000 being withheld for taxes.

However, this $20,000 remains untouched in the conversion. Because of the age of the account holder, the $20,00 stands as an early withdrawal, leading to a $2,000 penalty. Of course, the $2,000 penalty could have been avoided if the account holder paid the $20,000 in taxes through a non-retirement account. Many advisors fail to remember the penalty that younger account holders can face. Understanding all aspects of the conversion process is crucial, and it’s also worth noting that smaller amounts can be converted, enabling younger account holders to pay taxes out of pocket and avoid penalties.