Life and Death Planning for Retirement Benefits

248 / 507

248 Life and Death Planning for Retirement Benefits
would be includible in the participant’s gross income and would therefore be subject to the
penalty. See Reg. , A-3.
D. Conversion followed by distribution within five years. See for a special rule
that may result in a penalty being applied to the return of the participant’s own contribution.
5.5.02 Roth conversion prior to reaching age 59½
Roth conversions before age 59½ are very confusing, because there are TWO of
everything:
 There are TWO separate parts of the Roth IRA, the contribution(s) and the earnings.
 There are TWO different taxes to worry about, the income tax and the 10 percent
penalty.
 There are TWO completely different five-year holding periods!
A. Penalty does not apply to a Roth conversion. The 10 percent penalty does not apply to
the deemed distribution that results from converting a traditional retirement plan or IRA to
Roth status Reg. A-7(b); Notice 2008-
30, A-3. Thus a young person may convert his traditional plan or IRA to a Roth IRA
without penalty.
However, this does not mean he can forget about the 10 percent penalty. The 10 percent
penalty can still come into the picture in several ways. For one thing, the penalty would apply to
any income taxes withheld from the conversion amount such a tax payment would not
qualify for the “conversion exception” since it is sent to the IRS and not converted to a Roth IRA.
Also, the penalty applies to nonqualified distributions of earnings from the Roth account; see
B), (C). And:
B. Penalty applies to certain distributions within five years after a conversion. Though a
person who is under age 59½ can convert to a Roth IRA without penalty, he has to come
up with the money to pay the income tax on the conversion from some source other than
the newly-converted Roth IRA money, because he will owe the penalty to the extent he
taps that money, under the following special rule:
If a participant who is under the age of 59½ receives a distribution from a Roth IRA or
DRAC; and “any portion” of that distribution is allocable (se for Roth IRAs for
DRACs) to funds that were rolled over to the Roth account from a traditional plan account or IRA;
and “the distribution is made within the 5-taxable-year period beginning with the first day of the
individual’s taxable year in which the conversion contribution was made”; then th penalty
will apply to “such portion” of the distribution to the extent such portion was includible in the
employee’s gross income (unless an exception applies). Reg. A-
5(b); Notice 2008-30, A-3. See for the exceptions to the 10 percent penalty.
The penalty generally does not apply to distributions from a governmental 457(b)
plan. Accordingly, if the distribution comes from a DRAC in a 457(b) plan it will generally not be
subject to the penalty even if it represents a Roth conversion within five years; see The
exception: 457 distributions that represent money rolled into the 457 plan from another type of
plan are subject to the penalty.