Contributions to a traditional individual retirement account are made with gross, or pre-tax, earnings. You can use that money to buy shares in mutual funds as well as other types of investments. Contributions to Roth IRAs are made with after-tax dollars. You can convert your traditional IRA as Roth. If you keep the converted funds inside the Roth for five years and make no withdrawals until you are 59 1/2, then you pay no taxes on your account earnings. Traditional IRA withdrawals are subject to taxation. Despite the benefits, Roth conversions can also cause tax complications.
You can move complete a Roth conversion without having to sell or move your mutual fund shares if you fill out a conversion form with your IRA custodian. The custodian simply re-characterizes your existing account as a Roth rather than a traditional IRA. In doing this, you avoid paying fees to sell and re-purchase your shares. To complete the conversion you have to pay income tax on the entire amount that you convert. You should use separate funds to cover these taxes -- not funds from within the account -- to avoid paying early withdrawal penalty taxes. You also have to pay state income tax on the funds that you convert.
If you do not have sufficient cash reserves to pay the state and federal income tax on your conversion, you can use IRA funds to cover the taxes. This involves selling a portion of your mutual fund shares and using the proceeds to pay the taxes. If you have yet to reach the age of 59 1/2, then you incur a 10 percent premature withdrawal penalty if you use IRA funds to cover your taxes. You incur the penalty because you have to withdraw the money from the IRA when you pay the taxes, and premature IRA withdrawals incur tax penalties. These penalties may offset any long-term gains that you hoped to capture as a result of the conversion.
If you want to move your shares to a new custodian during the Roth conversion, then you can do so by completing an automated customer account transfer service form. Your traditional IRA custodian transfers the shares to the Roth IRA custodian so you avoid paying commissions related to the buying and selling of shares. You can either use outside funds to cover the taxes or liquidate a portion of the shares to cover the taxes, in which case you may incur the 10 percent penalty.
If you roll over your funds to a new custodian, then you take possession of the money and you have to reinvest it in the Roth within 60 days to avoid paying a 10 percent early withdrawal penalty and regular taxes. Your traditional IRA custodian sells your shares and you receive a lump sum of cash. You then have to buy new shares with the converted funds. Some types of shares have commissions known loads that you pay either when you buy or sell shares. Aside from paying federal and state income tax on the conversion, you also incur a 10 percent tax penalty if you use IRA funds to cover those taxes. Therefore, due to the sales commissions, rollovers involving conversions are more costly and complicated than other types of conversions.
- Schwab; 2010 Roth Conversion: Look Before You Leap; Rande Spiegelman; December 2009
- TD Ameritrade: What You Need to Know
- IRS.gov; Retirement Plans FAQs regarding IRAs; July 2011
- Kiplinger; State Taxes Vary for Roth Conversions; Rahcel L Sheedy; August 2010
- CNN Money; Rollover Versus Transfer; Ed Slott; May 2000