You can move some individual retirement arrangements into other plans without any tax penalties, but if you convert a traditional IRA into a Roth IRA you will owe taxes. With a traditional IRA, you get to deduct your contributions from taxable income when you make them, but pay taxes when you take money out. A Roth IRA is funded with after-tax money, but those funds and earnings aren't taxed when you take them out.
All Conversion Taxed
If you change your traditional IRA to a Roth IRA, you have to count all of the money you move as taxable income. It will be taxed at whatever your tax rate is, depending on your income, and could boost you into a higher tax bracket for that year. A way to estimate that cost is to look up last year's taxable income, add the amount in your IRA and look up that total on a Form 1040 tax table.
You don't have to convert an entire traditional IRA all at once. You can move it piecemeal over several years, so the tax hit is not large in any one year. You can plan this by figuring out how much additional income you can have before you move to the next higher tax bracket and convert only enough to keep you in the lower bracket.
Paying conversion taxes from rollover funds is an option, but usually not a good one. It reduces the balance in your converted IRA. It could also cost you a 10 percent penalty on the money if you're making the switch before age 59 1/2 and the transfer is considered an early withdrawal. Another consideration is what a conversion that pushes you into a higher tax bracket might to do other tax benefits, such as child tax or higher education credits.
Converting to a Roth is generally more favorable for younger taxpayers, who have less accumulated in a traditional IRA and may be in a lower tax bracket. It could be a financial burden for taxpayers nearing retirement, with a lot of money in an IRA. Converting to a Roth does, however, make it easier to leave money to heirs. Traditional IRAs require mandatory withdrawals starting at age 70 1/2, but Roth IRAs have no withdrawal requirements. Roth funds also pass to heirs tax-free.
Switching from one form of traditional IRA to another imposes no tax liabilities, so long as the money is transferred within 60 days. You can convert an employer-based simplified employee pension or SEP IRA to a traditional IRA, for instance, without any tax consequences. You can also convert from one IRA custodian to another without penalty. The transfers just have to be within the 60-day limit.
Bob Haring has been a news writer and editor for more than 50 years, mostly with the Associated Press and then as executive editor of the Tulsa, Okla. "World." Since retiring he has written freelance stories and a weekly computer security column. Haring holds a Bachelor of Journalism from the University of Missouri.