Taxes Related to an IRA Conversion to Roth

by Wilhelm Schnotz, studioD

There's no single retirement plan that's perfect for all investors, and sometimes your needs change midway through your retirement planning. A nest egg made up of contributions to an IRA might have seemed like a wise move 15 years ago, but the taxes on distributions may now seem less attractive, making a Roth IRA a much more attractive option. Perhaps you just like the accessibility of funds in a Roth over the penalties incurred for early distributions from an IRA. No matter what the reasoning, prepare to pay taxes on the amount you convert from a traditional IRA to a Roth.

Income Taxes

The largest difference between an IRA and a Roth IRA is the way the IRS treats contributions. You contributed funds to your traditional IRA on a pretax basis, meaning they were deducted from your net taxable income for the year. The income taxes on these contributions is delayed until you receive distributions, at which time it's taxed at your applicable income tax rate. Contributions to Roth IRAs aren't deductible, and come after taxes -- although when you receive distributions you aren't taxed on the amount. When you convert a traditional IRA to a Roth, the IRS assess income taxes against the entire amount you convert, at the applicable tax rate according to your income. Thus, if you're in the 25 percent tax bracket and convert $10,000, plan to pay $2,500 in taxes.

Early Distribution Penalty

If you choose to pay income tax assessments on the converted funds from money you roll over to a Roth, the IRS treats that strategy as an early distribution from an IRA. In addition to all income taxes paid on distributions, the IRS charges a 10 percent excise tax as a penalty if you take an early distribution. So if you roll over $10,000, incurring a $2,500 income tax assessment and plan to withdraw the money from your Roth to pay for it, you'll face an additional $250 in penalties.

Partial Conversion

Converting a large IRA to a Roth may drastically increase your annual earnings and, in turn, push you into a much higher marginal tax bracket. To avoid paying a higher tax rate on a portion of the rollover, you may consider slowly converting the fund in a series of partial conversions. The IRS allows you to convert any amount of your IRA to a Roth, so careful management of the amount converted each year can keep the process from temporarily elevating your tax rate. Funds converted to a Roth must remain there for five years, however, so plan ahead accordingly.

Future Roth IRA Distributions

The taxes associated with converting a traditional IRA to a Roth may seem steep, particularly if you plan to convert a large amount of funds. The maneuver has tax advantages that may outweigh the costs to some investors, though. Once you place funds in a Roth IRA, you can receive qualifying distributions -- those made after you turn 59 1/2 -- without paying taxes on them, so you immediately resolve your tax burden. Distributions from a traditional IRA are taxed when you receive them.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.