Understanding the 10% Penalty and Roth IRAs

One of the more confusing aspects of Roth IRAs is the 10% penalty for early distributions. The penalty is different for regular Roth IRAs and converted Roths. Tax-free distributions from Roths might be penalized. Don’t confuse the rules on taxes with the penalty.

The same penalty and exceptions apply to traditional and Roth IRAs, unless the Roth rules say otherwise. An early distribution occurs when the IRA owner is under age 59½, unless an exception applies. The most likely exceptions are the disability or death of the owner, or the distributions are a series of substantially equal payments.

For regular Roth IRAs the rules are essentially the same as for traditional IRAs. One exception is that a distribution from a Roth IRA is treated as first coming from contributions. These are tax free and penalty free. But after all contributions are distributed, earnings are distributed and potentially subject to taxes and the penalty.

The penalty is different for converted Roth IRAs. It does not apply to the taxable converted amounts in the year of conversion. If the owner takes a distribution to pay the taxes, the penalty might apply to that amount.

After the conversion, a five-year waiting period for the penalty begins if the owner is under age 59½, even if the owner had another Roth for more than five years. If the owner takes a distribution of converted amounts within five years after the first day of the year of the conversion, the 10% penalty will apply if the owner is under age 59½ unless one of the exceptions applies. The penalty is applied to all converted amounts. There is no exception for amounts on which taxes were paid on conversion.

RW October 2009