You make after-tax contributions to a Roth individual retirement arrangement but only if your income does not exceed certain levels. However, people who earn too much to invest directly in Roth IRAs can use Roth conversions to move money from other retirement accounts into Roth IRAs. No income restrictions apply to Roth conversions and you can move your money all at once or in increments over the course of a single year or over the course of several years.
Roth IRAs provide you with tax-free earnings, whereas you have to pay income tax on the money you earn when you invest in other types of retirement accounts. You avoid paying tax on Roth withdrawals if you keep the money in the Roth for five years or more and make no withdrawals prior to age 59 1/2. You have to pay income tax on your principal prior to investing in a Roth so you do not pay tax on withdrawals of principal. With a traditional IRA, you deposit your money pre-tax but you have to pay income tax on both your principal and your earnings when you make a withdrawal.
When you convert money from a traditional IRA to a Roth, you have to pay income tax on the money that you convert. The addition of these funds to your taxable income could cause you to move into a higher tax bracket. The tax year ends in April so it does not coincide with the end of the calendar year. Therefore, some people move a portion of their money to a Roth before the end of the tax year but hold some money back so as to not move into a higher tax bracket for the tax year. After the tax year ends, you could move more funds to the Roth within the same calendar year because that money counts as taxable income for a different tax year.
You can invest IRA money into certificates of deposit, annuities, mutual funds and many other types of investments. Some investments are highly liquid, which means you can convert those funds to a Roth without incurring a penalty. In other instances, you have to pay penalty fees if you liquidate a CD or annuity before the end of the product contract. You can avoid paying penalty fees by staggering your Roth conversion so that you just move funds as and when each of your CDs or annuities mature.
When you convert money to a Roth you can either use separate funds to cover the taxes or you can pay the taxes with IRA funds. However, if you have yet to reach the age of 59 1/2, you have to pay a 10-percent tax withdrawal penalty when you withdraw IRA funds for the purpose of paying tax on your conversion. Some people move money to Roths incrementally when they raise the cash to cover the taxes. You may have moved a small sum to a Roth earlier in the year and thereafter you receive a bonus at work or a cash inheritance that enables you to move over additional funds.