In general, an early payout from an individual retirement account (IRA) before the age of 59½ is included in gross income plus an additional tax penalty of 10 percent. There are exceptions to the 10 percent penalty, such as using IRA money to pay your health insurance premium after losing your job. Since the IRS wants you to save Roth IRA money for your retirement, withdrawing them too early is frowned upon. It is defined too early as the age of 59½ years.
If you’re younger, you’ll generally have to pay income taxes and the 10% upfront withdrawal penalty on any income you deduct from the account. While you can’t contribute to a Roth IRA if your income exceeds the limits set by the IRS, you can convert a traditional IRA to a Roth IRA, a process sometimes referred to as a backdoor Roth IRA. Switching a traditional IRA or fund from a SEP IRA or SIMPLE plan to a Roth IRA can be a good choice if you expect to be in a higher tax bracket in your retirement years. When you convert a traditional IRA to a Roth IRA, you pay taxes on the converted money to secure tax-free withdrawals in the future, as well as various other benefits, including no required minimum distributions.
You can convert as much as you want from a traditional IRA to a Roth IRA, although it’s sometimes wise to spread out these transfers for tax purposes. That means you won’t get a tax deduction on contributions if you make them, but then you won’t be taxed on distributions if you accept them (the opposite of how traditional IRAs work). It is generally advisable to carry out the conversion over several years and, if possible, convert more into years when your income is lower. Roth IRAs can be an excellent source of tax-free income, but it’s important to understand the nuances of payout rules, particularly the 5-year rule in all its variants.
Roth IRA beneficiaries can withdraw contributions from an inherited Roth account at any time (this is even required). When you convert a traditional IRA to a Roth IRA, you owe tax on any money in the traditional IRA that would have been taxed when paid out. Subject to various exceptions, if you make a withdrawal from a traditional IRA before reaching the age of 59, you will also be charged a 10% penalty for any portion of the distribution that is taxable. If you want to keep your distributions free from taxes and tax penalties, you need to understand the pros and cons.
You may have made a conversion that is only partially taxable because you made non-deductible contributions to a traditional IRA before the conversion. If the value of your retirement account has dropped, this could be a good time to switch to a Roth IRA, as the tax impact is less onerous than if your account is worth more. So if you’re lucky enough not to have to withdraw money from your Roth IRA, you can simply let it continue to grow and let your heirs withdraw tax-free one day. To keep the tax impact as low as possible, it may be advisable to divide large account conversions over several years or wait until your income or asset value is low.
However, this one-year limit does not apply to conversions where you rollover from a traditional IRA to a Roth IRA.