Tax Consequences for Rolling a Mutual Fund IRA into a Roth Mutual Fund

Both Roth and traditional IRAs can provide tax advantages for your mutual funds.

Both Roth and traditional IRAs can provide tax advantages for your mutual funds.

Both a traditional individual retirement account (IRA) and a Roth IRA are tax-advantaged investment vehicles designed for retirement savings. Each type of account allows investments in mutual funds, and most taxpayers are eligible to roll over funds from a traditional to a Roth IRA. However, the tax consequences of rolling funds over can be significant, since money in traditional and Roth IRAs is taxed differently.

Federal Income Tax

The main difference between traditional and Roth IRAs is that traditional IRAs are funded with pre-tax money, while Roth IRAs are after-tax vehicles. When you contribute to a traditional IRA, you are allowed a tax deduction that you don't receive for Roth contributions. As a result, distributions from the two types of accounts are reversed as well -- traditional IRA distributions are fully taxable, while Roth distributions are typically tax-free. When you roll over your money from a traditional IRA to a Roth IRA, the amount you roll over is fully taxable, since you are moving from a pre-tax vehicle -- the traditional IRA -- to an after-tax vehicle (the Roth IRA).

State Income Tax

If you live in one of the seven U.S. states that don't collect income tax, your tax liabilities on your IRA rollover may end with the federal government. Taxpayers in the remaining 43 states must pay state income tax on top of federal income tax for any traditional-to-Roth IRA rollovers. Technically, income from a rollover or conversion to a Roth IRA is included in your gross income, rather than assessed a distinct federal tax. Since income tax returns for states are based on the amount of gross income on your federal tax return, you will be liable for state tax if your state assesses it.

Penalties

You have two basic options when rolling over money to a Roth IRA. The first option is a direct rollover, which is an electronic transfer to your new IRA custodian (the firm that administers the paperwork for your IRA). A second option is to simply receive a check for the funds, which you are then personally responsible for depositing into your Roth IRA. If you choose to get a check, you have 60 days to deposit it into your Roth. The IRS classifies rollovers that are not completed within 60 days as distributions, subject to taxes and penalties. While you have to pay the taxes whether or not you actually complete the rollover, if you are under age 59 1/2 and fail to complete the rollover, you'll owe an additional 10 percent to the IRS as an early-distribution penalty.

Higher Tax Bracket

Your tax consequences may be higher if you choose to roll over your money to a Roth all at once rather than over time. Since all of the rollover money is included in your gross income, a large rollover may kick you into a higher tax bracket. If you choose instead to roll over a small amount of your IRA every year, you may be able to avoid this higher tax penalty.

 

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