To discourage people from raiding their individual retirement accounts, the Internal Revenue Service levies a 10 percent additional tax on taxable early distributions. Early distributions for traditional IRAs include only those distributions taken before you turn 59 1/2 years old. When converting money from a traditional IRA to a Roth IRA, the penalty may come into play.
With a Roth IRA conversion, the 10 percent early withdrawal penalty doesn't apply to any amount that gets rolled into the Roth IRA. For example, if you take $50,000 out of your traditional IRA and deposit the full $50,000 in your Roth IRA, you don't have to pay the 10 percent early withdrawal penalty because you haven't withdrawn any of the money.
Portion Used for Taxes
Because a Roth IRA conversion results in taxable income, it's not uncommon for taxpayers to want to use some of the conversion to pay those taxes. But if you take a distribution from your tax-deferred retirement account to pay the income taxes on the conversion, that portion is subject to the early withdrawal penalty if you're under 59 1/2. The IRS does not offer an exception to the penalty for amounts used to pay conversion taxes.
SIMPLE IRA Conversions
You won't have to pay the 10 percent penalty, but the result is worse if you attempt to convert money from a SIMPLE IRA to a Roth IRA within two years of opening the SIMPLE IRA. If you try to convert before two years have passed, it counts as a distribution from the SIMPLE IRA, subject to taxes and the 25 percent penalty for withdrawals in the first two years, as well as an annual contribution to your Roth IRA. If the contribution is more than your annual limit, you also owe excess contribution penalties.
Other Negative Tax Implications
Some tax benefits are limited to folks with incomes below a certain level. For example, you can't claim any of the tax benefits for education -- the American opportunity credit or lifetime learning credit -- if your income is too high. In addition, your medical expenses deduction and miscellaneous deductions are limited to the portion that exceeds a percentage of your adjusted gross income. So, not only would you owe taxes on the conversion, you could also lose other tax breaks.