401k rolled over to Simple IRA then Roth

What is the name of your state? Florida, age 35

Here's the scenario:

Lets say I have $40,000 in my 401K. I started a new job that does not have a 401k. I can of course keep it with my current 401k company or roll it into a tradional IRA. I decided to place it in the simple IRA. There is no penalty for this.

Next:

I have $45,000 in worthless stocks. I request a check for entire amount of $40,000 from simple IRA. They will send me a 1099 showing amount they sent me. (penalties are usually your tax bracket plus 10 % if I am correct) If I sell these stocks this year could I use the loss of the stocks to offset any taxes or early withdrawal penalties owed on the $45,000 simple IRA amount withdrawn?

Finally:

If so, I would use the entire amount of $40,000 to place tax free into a Roth IRA account. Would this all be legal and a good idea?
I still have 32 years before I can use it and it would be great not to pay taxes when I retire. This amount would be tax free including all profits from the principle.

NO! You can only take a maximum of $3,000 per year capital loss to reduce ordinary income. If you withdraw the $40,000, you'll have $4,000 in penalties & $37,000 in taxable income. This would be bad.

Try selling your worthless stocks now (carry forward the losses) and convert $3,000/year to a Roth. The stock loss will exactly offset the Roth conversion income. There are no penalties for converting to a Roth. You could even convert a little more & just pay the tax on the amount over $3,000.

There are also certain times when you can withdraw money from an IRA without penalty (i.e., buying your first house in 2 years or going to college).

Capital gain vs capital loss

But if I have $45,000 of capital losses to $40,000 capital gains, the losses should offset the gains. My financial advisor said this would work.

The $40000 withdrawn from a 401(k) or IRA (doesn't matter) is considered ordinary income, not capital gains. You can only offset up to $3000/year in capital losses against ordinary income.