When you complete a Roth Individual Retirement Arrangement conversion, you move funds from a pre-tax traditional IRA to an after-tax Roth IRA. Income limits apply to annual Roth contributions but do not apply to Roth conversions, so anyone can move funds to a Roth. Aside from converting your entire IRA to a Roth, you can also complete a partial conversion, and doing so may save you money in terms of taxes and fees.
When you move funds from a traditional IRA to a Roth, you have to pay income tax on the entire amount that you withdraw because you can only deposit already taxed money into a Roth. Thereafter, you pay no income tax on qualified Roth withdrawals before age 59 1/2 if the account has been open for five years. The funds you convert are added to your taxable income in the year of the conversion. These additional funds could cause you to move into a higher tax bracket, and the subsequent taxes could more than offset your potential long-term savings. If you complete a partial withdrawal, you can avoid moving into a higher tax bracket by limiting the amount of your conversion.
To discourage people from using retirement accounts as a short-term device to avoid income tax, the Internal Revenue Service imposes a premature withdrawal penalty if you access traditional IRA funds before reaching the age of 59 1/2. You do not pay this fee on funds that you convert from a traditional to a Roth as long as you use separate funds to cover the income tax on the conversion. If you pay the income tax with the IRA funds, then you do have to pay the premature withdrawal penalty. If you have enough cash outside your IRA to cover the taxes on a partial conversion, then you can avoid the tax penalty by moving just a portion of your IRA funds to a Roth.
IRAs often contain a wide variety of investments such as certificates of deposit, mutual funds, stock and bonds. You have to pay a penalty fee if you cash in a CD or annuity during the term time. You may also have to pay a commission known as a back-end load if you sell certain kinds of mutual funds within a specific period of time after the purchase date. You can avoid paying penalty fees by only converting readily accessible funds to your Roth and leaving other funds in the IRA until you can liquidate your other assets without penalty.
You should consider a partial conversion rather than a full conversion if you expect to start making withdrawals from your Roth within the next five years. Regardless of age, you incur a 10 percent tax penalty on earnings in your Roth if you access the money within five years of the investment date. However, if you have no long-term need for your money then, depending on your current tax bracket, you should consider a full conversion. If you never use the funds in a Roth, your heirs can access that money after you die without having to pay income tax. Your heirs do pay income tax on money inherited from a traditional IRA.