Q: When you explained how to pay for a Roth conversion with IRA money, you mentioned that a 10% penalty can apply to converted money. Why is that?
Traditional vs. Roth IRA
A: The penalty applies when the taxpayer converts before age 59½ and decides to pay taxes on the conversion with funds from the IRA.
Let's look at what happens when you withdraw money from an IRA and have some money withheld for taxes. Say, you pull $20,000 from an IRA and withhold 20% for taxes. $4,000 (20% of $20,000) is sent to the U.S. Treasury and you get a check for $16,000. The $20,000 is the total distribution and you have $20,000 of taxable income to report to the IRS, assuming all of the IRA is pretax.
The same thing happens if you convert $20,000 to a Roth IRA and withhold 20% for taxes, except your check goes to the Roth IRA. $20,000 was distributed from the IRA and is reported as taxable but only $16,000 landed in the Roth IRA because $4,000 went to Uncle Sam.
Funds converted to a Roth aren't subject to a 10% penalty in the year of the conversion. However, the $4,000 that went to the IRS isn't considered converted because it didn't go into the Roth IRA. It was distributed and if you are under 59½ subject to a 10% penalty.
The penalty only applies to the amount of the distribution, the $4,000 in this case. So, in addition to whatever taxes are due on the $20,000 that left the traditional IRA, and additional $400 in penalty will be owed. This extra cost makes converting less attractive because the effective tax rate on the conversion is higher.
Even if you are older than 59½ and therefore unaffected by the 10% penalty, it is still better to pay the taxes on a conversion with funds in a taxable account. By paying like that, you lower the amount of money in the taxable environment of a nonretirement account while also maximizing the amount of money in the tax-free environment of a Roth.