Does the 10% Premature Distribution Penalty Apply to Roth Conversions?

“Our 403(b) plan allows for both Roth contributions AND Roth conversions. We have an active employee who is 30 years old who wishes to make a Roth conversion. She realizes that she is subject to ordinary income tax on the amount of the conversion, but she wanted to know if the 10% premature distribution penalty applies to the conversion. What say the Experts?”

Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:

We’ll get to what the Experts say in a moment, but this is a great opportunity to point out that sometimes it takes a very careful reading of the Code/Regs to find your answer.

Case in point: Section 402A(c)(4), which is the Code Section that ostensibly addresses this question. Let’s look at subparagraph (A) (boldface text reflects the Experts emphasis):

(4)Taxable rollovers to designated Roth accounts

(A)In general

Notwithstanding sections 402(c), 403(b)(8), and 457(e)(16), in the case of any distribution to which this paragraph applies—

(i)there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution,

(ii)section 72(t) shall not apply, and

(iii)unless the taxpayer elects not to have this clause apply, any amount required to be included in gross income for any taxable year beginning in 2010 by reason of this paragraph shall be so included ratably over the 2-taxable-year period beginning with the first taxable year beginning in 2011.

Any election under clause (iii) for any distributions during a taxable year may not be changed after the due date for such taxable year.

So, clearly, a rollover to a Roth account is NOT subject to the 72(t) 10% premature distribution penalty. But, is a Roth conversion within a 403(b) plan a rollover? Let’s read on:

(B)Distributions to which paragraph applies

In the case of an applicable retirement plan which includes a qualified Roth contribution program, this paragraph shall apply to a distribution from such plan other than from a designated Roth account which is contributed in a qualified rollover contribution (within the meaning of section 408A(e)) to the designated Roth account maintained under such plan for the benefit of the individual to whom the distribution is made.

OK, so for a rollover of a distribution from any applicable retirement plan (of which a 403(b) is one) that includes a Roth account, paragraph (4) (waiving the 10% premature distribution penalty) shall apply. So we’re getting closer; it looks like that this language would apply to same-plan rollovers to Roth, but it is not 100% clear as to whether a conversion of amounts that are not otherwise distributable from the plan (as would be the case here), which is more akin to a transfer than a rollover, satisfies this definition. However, if you read on to clause (E), the answer becomes clear:

(E)Special rule for certain transfers

In the case of an applicable retirement plan which includes a qualified Roth contribution program—

(i)the plan may allow an individual to elect to have the plan transfer any amount not otherwise distributable under the plan to a designated Roth account maintained for the benefit of the individual,

(ii)such transfer shall be treated as a distribution to which this paragraph applies which was contributed in a qualified rollover contribution (within the meaning of section 408A(e)) to such account, and

(iii)the plan shall not be treated as violating the provisions of section 401(k)(2)(B)(i), 403(b)(7)(A)(ii),[1] 403(b)(11), or 457(d)(1)(A), or of section 8433 of title 5, United States Code, solely by reason of such transfer.

Bingo! It is now clear that all in-plan Roth conversions are indeed the type of “distribution” under clause (B) to which paragraph (4), which waives the 10% premature distribution penalty, would apply. Thus, Roth conversions are NOT subject to the 10% premature distribution penalty under Code Section 72(t) even though such conversion are subject to ordinary income taxes. However, it takes a careful reading to uncover the Code citation to support this fact, as is sometimes the case!

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.