Beware the Roth Conversion Penalty Trap

Roth conversions are a great way to generate a source of future tax-free income for even high-earning clients. Typically, tax is paid on the amount converted in the year of conversion and the amounts converted are exempt from the 10% early withdrawal penalty. In the best of cases, the taxpayer will have the funds to cover their tax liability outside of the Roth account. However, some clients must resort to withholding tax liability from the amount of the conversion itself. In these cases, it's important to remember the 10% early withdrawal penalty before the amounts are taken from the traditional IRA and sent to the IRS. If the client is not yet 59 1/2 (and no other exception applies), the IRS will tack the 10% penalty tax on to the amount withheld for taxes because there is no exception to the penalty for amounts paid to the IRS via withholding. In other words, those amounts do not qualify for the exception for Roth conversions because those amounts are never actually transferred into the Roth account. For more information on Roth conversions, visit Tax Facts Online. : Q 3673.