One of my clients called with an interesting question.
"I need to take the money out of my IRA" he explained. "I know I have to pay income tax, but I think I found a way to avoid paying the penalty" he continued. He certainly got my attention and I was all ears. "What I want to do is convert my IRA to a Roth IRA. I will pay the income tax on the conversion. Since after the conversion I can withdraw my Roth contributions at any time without penalty, I can liquidate the Roth right away and avoid the 10% penalty" he explained.
For a while I was stumped because, at first glance, it seemed logical. But something in the back of my mind told me there was a rule or regulation that prohibited that very circumstance. So I called a good friend and former co-worker of mine, Dave Breuer, CFP®. Dave and I worked together ten years ago when we were both Advanced Market Consultants at the same company. Our job was to provide advice and support for the company's advisors who's clients had complex estate planning, business planning, and retirement planning issues. We were partners when the Roth IRA went into effect and we had both spent considerable time studying the intricacies of program when the tax code was our only resource.
Dave was quick to find the answer (I knew he would be). Distributions from a Roth IRA conversion are still subject to the 10% penalty for 5 years after the conversion.
But Dave and I never give up at the first roadblock. We even considered the potential for avoiding the penalty by converting an IRA into a Roth IRA which was already over 5 years old but unfortunately someone else had thought of that before we did and closed that potential loophole too. If converted IRA contributions are co-mingled with ordinary Roth contributions, distributions from that Roth are treated as FIFO (first in, first out). You can withdraw the ordinary contributions without paying the penalty only up to the amount in the Roth prior to the conversion. If that amount is exceeded, then the 5 year limitation is applied.
I have to give a lot of credit to my client for his creative thinking, but thankfully he checked with me before he put his plan into action. I was able to save him from a nasty 10% surprise next April.
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