Question

Parker, age 48, has a traditional Ira with a balance of $50,000. The $50,000 balance consists of $30,000 of contributions and earning of $20,000. This year Parker's marginal tax rate is 24%. Parker is convinced that his marginal tax rate will increase in the future. Parker decides to cash out his IRA and received $50,000 this year. He contributes $40,000 of these $50,000 to a Roth IRA. How much income tax and penalty must Parker pay this year?

-Income tax __

-Penalty __

Answer 1

Assumption: Traditional IRA is deductible IRA that means contribution to IRA is deductible and entire distribution that is contribution and earning is taxable at marginal tax rate.

As per publication 590 of IRS Code:

- Income Tax

Traditional IRA both contribution i.e. principal and earning i.e. interest on earning is taxable as ordinary income at time of distribution.

So in given case of parker both contribution and earning is subject to marginal tax rate at time of distribution.

- Penalty

Distribution age limit for traditional IRA is 59.5 years. That means withdrawal before 59.5 years age limit is subject to 10% Penalty over above tax on distribution

EXCEPTION RULE:

If distribution is contribution to another IRA within 60 days from distribution one is not suppose pay additional 10% early withdrawal penalty tax.

So given case though age limit is below distribution age but $40,000 is used to contribute in Roth IRA parker is not subject to penalty on $40,000 distribution.

Calculation for income tax and penalty for Traditional IRA.

- Income Tax

$30,000 contribution + $20,000 earnings both taxable at marginal rate.

$50,000 × 24% = $12,000

Penalty

$10,000×10% subject to penalty as it is not used for converting traditional IRA to Roth IRA.

$1000.

INCOME TAX $12,000

PENALTY $1000.

Conversion from traditional to Roth IRA is allowed by paying income tax on income tax on distribution.