Early Withdrawals from 2010 Roth Conversions Will Accelerate Taxation

A taxpayer doing a Roth IRA conversion in 2010 has the opportunity to delay taxation on the conversion by reporting one half of the conversion amount as income on the 2011 tax return and the other half as income on the 2012 tax return.

What happens if tax deferral is elected, and withdrawals are taken from the converted Roth IRA prior to 2012? Congress and the IRS have developed rules to accelerate the taxation for such withdrawals.

Here’s how it works. Suppose Client A converts a $100,000 traditional IRA into a Roth IRA in 2010. Assuming no withdrawals, Client A would report $50,000 of income on the 2011 tax return and $50,000 of income on the 2012 tax return.

Suppose, however, that Client A after doing the 2010 conversion, takes a $10,000 distribution from the converted Roth IRA during 2010. This would accelerate the taxes and Client A would then report $10,000 of income on the 2010 return, $50,000 of income on the 2011 return, and $40,000 of income on the 2012 return.

Now, suppose further, that Client A takes a $20,000 withdrawal during 2011. Here’s the tax reporting for that situation: $10,000 of income reported in 2010; $70,000 of income reported for 2011 ($50,000 + the $20,000 withdrawal); and $20,000 of income reported for 2012.

In addition to acceleration of taxes, if the client is under age 59-1/2, the 10% penalty comes into play. If converted amounts are withdrawn from a Roth IRA prior to the earlier of

• five years from the conversion date or
• attainment of age 59-1/2,

the 10% early distribution penalty will apply.

Thus, in our example of Client A, who is under age 59-1/2, the $10,000 withdrawal in 2010 would not only be reported as ordinary income but also subject to a 10% penalty. In year 2011, Client A would report $70,000 of taxable income; the $20,000 withdrawal would be subject to the 10% penalty, but the $50,000 conversion amount would not.

What if in addition to doing the Roth conversion, Client A makes annual contributions of $5,000 (or $6,000 if over age 50) to the converted Roth IRA? This certainly complicates the situation, but IRS has an ordering rule. Distributions come out in the following order:

(1) annual contributions,
(2) converted amounts, and
(3) earnings.

Thus, if Client A did a $100,000 Roth conversion, made a $5,000 annual contribution, and then later withdrew $10,000 in 2010, the $10,000 withdrawal would be first considered a return of the $5,000 annual contribution and then a distribution of $5,000 of converted money.

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