Roth conversions look good

Dear Dollar Diva,
I wanted to convert my traditional IRA account to a Roth IRA account a while ago, but couldn't afford the $4,000 tax bite. The market is down, and so is the value of my IRA. If I converted it now, the tax bite would be affordable.

Are there any restrictions about converting it into a Roth? I've heard that if our gross income is more than $100,000, we can't do it. What's the story?

Carol

Converting a traditional IRA account to a Roth IRA account when the market is down is a good idea. You pay less tax because you're reporting less income; and you pay no income or capital gains tax when the market bounces back in the future, because that's what the Roth IRA is all about.

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For more on the Roth IRA read the Diva's "Time is on your side with a Roth IRA," "How do Roth IRA contributions work?" and "Is the Roth IRA too good to be true?"

Restrictions

There are only two restrictions that you have to worry about when converting a traditional IRA to a Roth IRA:

Income limitation: If the gross income reported on your tax return (not including the conversion amount) is more than $100,000, you're not eligible to do the conversion. $100,000 is the magic number whether you're single or married, and it's not surprising that this income limit penalizes a lot of hard working married folks.
Filing status: A taxpayer filing "married filing separately" is not eligible to convert to a Roth, regardless of how little his income is. Every other taxpayer is eligible, as long as the gross income on his tax return is under $100,000.

To avoid getting thwarted by the marriage penalty, a single taxpayer with a good job should consider converting his traditional IRA to a Roth before he ties the knot.

For more details, read IRS "Publication 590, Individual Retirement Arrangements (IRAs) (including Roth IRAs and Education IRAs)."

For every action there's a reaction

Converting a traditional IRA to a Roth IRA adds a big chunk of taxable income to your tax return. The Diva reminds you of the potential negative tax consequences you should look out for:

Your marginal tax rate could jump into the next bracket: current tax brackets range from 15 percent to 39.6 percent.
Capital gains tax may jump from 10 percent to 20 percent.
Itemized deductions may be reduced or eliminated.
Deduction for student loan interest may be reduced or eliminated.
Child tax credit and credit for higher education tuition may be phased-out or eliminated.
Exemptions for taxpayer, spouse and dependents may be reduced or eliminated.
Up to 85 percent of Social Security may be taxed.

For the nitty-gritty on how adjusted gross income impacts your deductions and credits, read IRS "Publication 17, Your Federal Income Tax, For Individuals."