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Retirement: What You Need to Know About Roth Conversions

By Mary Beth Franklin, Source: Your Money Kiplinger

1. Good news: You're eligible. Until now, only taxpayers with income of $100,000 or less were permitted to convert a traditional retirement account to a Roth IRA. But the income-eligibility limit on Roth conversions disappears on Jan. 1 (income-eligibility limits on contributions remain in effect). That means that high earners can now hop on the tax-free-retirement-income gravy train.

2. And just in time. With federal budget deficits expected to top $9 trillion over the next 10 years, it's a safe bet that income taxes will increase to deal with the rising sea of red ink. That makes a compelling argument for converting assets in traditional IRAs, which will be fully taxed when you tap them in retirement, to tax-free Roths. The catch is that you must pay income taxes at your current rate on any amount you convert. Plus, if you're younger than 59 1/2, your Roth must be open at least five years before you can tap the converted amount penalty-free. After that, all of your Roth withdrawals, including earnings, are tax-free and penalty-free once you turn 59 1/2.

3. Plus, no tax payments for one year. If you convert to a Roth in 2010, you're entitled to extra time to pay your taxes. Although you will be taxed on the entire amount you convert, you can spread the bill over the next two years, reporting half of the conversion on your 2011 tax return and the balance on your 2012 return. This is not an all-or-nothing deal; you can convert a portion of your IRA at any time and pay the taxes as you go. But the option to spread the tax bill over two years is available only if you convert in 2010.

4. The sooner you act, the better. You'll owe taxes on the value of the IRA as of the conversion date. So making the switch early in 2010 will save you money if the account value continues to grow throughout the year.

5. You could hedge your bets. You might divide the converted amounts among multiple Roth IRAs according to asset class. Say, for example, your stock funds soar but your bond funds tank. You end up with a bargain tax bill on the winning stock-portfolio account, and you can convert the losing bond account back to a traditional IRA (also known as a recharacterization) without a tax liability.

6. The feds aren't going to hit the undo button. No need to worry that Congress will one day eliminate the tax-free Roth after you've paid your taxes. The taxes collected on Roth conversions are a moneymaker for the cash-strapped U.S. government. If Congress were to decide to kill the Roth, existing accounts would likely be grandfathered -- or lawmakers would face a taxpayer revolt.

(Mary Beth Franklin is a senior editor at Kiplinger's Personal Finance magazine. Send your questions and comments to moneypower@kiplinger.com. Visit www.kiplinger.com for additional advice and features.)