Traditional IRA to Roth IRA question

[hankmoody]

Hey guys,

Question, so I converted my solo 401k into a traditional IRA. The past 2 years I have been converting the maximum amount I can into my roth ira without having to pay taxes. I know I have to wait 5 years to withdraw this amount from each conversion (around 20k each time). I have a question though. What if I was to convert say 300k from my traditional IRA to my roth IRA this year. Obviously I have to pay the taxes on this this year. But what about in 5 years from now? Am I able to withdraw this 300k without any taxes (since i already paid taxes on the conversion from tIRA to rIRA) and minus the 10% penalty fee? Is this 300k conversion considered a "contribution". I know I would be paying a ridiculous amount of tax to do this and it's far from tax efficient and I'm not really considering doing it. I'm just wondering how this "conversion" is regarded and how the 10% penalty fee would apply or not apply to this large "conversion".

Thanks.

[gocurrycracker]

I would think of this as 2 different transactions.

1 - Roth conversion of $x - you can withdraw this in 5 years without taxes or penalty

No taxes, because there are no taxes on distributions of seasoned (5-year) Roth conversions.
No penalty, because the penalty only applies to non-qualified withdrawals (simplistically: earnings before age 59.5.)

2 - A tax payment now/today on the Roth conversion

For simplicity, let's just say total tax on the conversion is $1.

Where does that dollar come from?

If you pay it from cash in hand then there are no taxes.

If you sell some stock in a taxable account to get the $1, you might have some capital gains taxes.

If you withdraw an extra $1 from your Traditional IRA, then that distribution will be subject to taxes (always) and penalty (before age 59.5.)

If you withdraw an extra $1 from your Roth IRA, then taxation of that dollar is based on the ordering rules for Roth distributions.
- funds first come from original contributions (zero tax)
- then from Roth conversions in first-in first-out order (zero tax on seasoned conversions)
- lastly from earnings (subject to tax and penalty)

Ideally the taxes would be paid from cash on hand or funds from the brokerage account to avoid penalty and maximize deferred growth.

Most people have an extra $1 lying around, but this could be problematic with large conversions (~$54k tax due on $300k conversion for MFJ in 2020 with no other income.)
https://www.gocurrycracker.com/federal-income-tax-calculator/