You can move funds between multiple IRA accounts without any tax liability as long as the accounts are both traditional IRAs or both Roth IRAs. There are tax consequences when you transfer money from a traditional IRA to a Roth. You’ll need to factor in these taxes to decide if such a transfer is to your advantage.
The Internal Revenue Service calls a transfer from a traditional IRA to a Roth a conversion. The funds in traditional IRAs are pre-tax dollars. You pay the taxes on contributions and investment earnings when you withdraw money from the account. There is no tax deduction for Roth contributions, so Roth money is after-tax. The Roth tax advantage is that both your contributions and investment earnings are considered after-tax funds and therefore tax-free when withdrawn after you reach age 59-1/2. To transfer money to a Roth, you must convert the pre-tax traditional IRA dollars into after-tax dollars by paying income taxes on the transferred money. In effect, you give up the tax-deferred status of your traditional IRA money in exchange for the Roth tax benefits.
The money you transfer from a traditional IRA to a Roth is added to your other income in the year of the conversion. It is taxed at your highest tax bracket, or marginal tax rate. As an example, assume you are in the 28 percent tax bracket. The converted money will be taxed at a rate of at least 28 percent. If you convert a large amount of money, you could be pushed into the next higher bracket and end up paying 33 percent on much of the transferred assets.
When you or your spouse is covered by a retirement plan at work and you make too much money, the tax deduction for your traditional IRA contributions is reduced or eliminated. If you make contributions to your traditional IRA anyway, they are called nondeductible contributions. These funds won’t be taxed in a conversion to a Roth because you already paid taxes on them. You cannot transfer only nondeductible funds. If you make a partial transfer, the nondeductible portion has to be allocated in proportion to the amount of money you move. For example, if you transfer 60 percent of your traditional IRA, allocate 60 percent of your total nondeductible contributions.
Paying the Taxes
The IRS waives the normal 10 percent early withdrawal penalty for assets you convert to a Roth IRA. However, the waiver applies only to money that actually goes into the Roth account. If you hold out any to pay the income taxes due on the money you transfer, you will have to pay the 10 percent penalty tax on the money you used to pay the taxes. You can avoid the penalty by using cash from another source such as a savings account.