Thanks to new rules that went into effect in January, for the first time ever, every American with an IRA can qualify for conversion to a Roth IRA, creating the opportunity for tax-free growth of their retirement investment dollars. But converting a traditional IRA to a Roth is considered a taxable event, which means you'll owe taxes on the money that is converted, less any nondeductible contributions made to the traditional IRA.
If you're considering converting IRA assets to a Roth, first determine how you'll pay the associated taxes.
Part of the good news about Roth conversion is that the new 2010 rules include an option to spread the taxes out over two years, paying half each year. "If you convert in 2010, you'll have until tax year 2012 to pay all the taxes, which means you won't have to finish paying them until April 2013," says Greg McBride, senior financial analyst at Bankrate.com. "If you make the conversion in January 2010, you'll have 27 months to pay the first half and 39 months to pay the second half." While the new Roth eligibility rules are permanent, 2010 is the only year when taxes can be paid in two subsequent tax years; after 2010, all taxes will be due during the tax year in which the conversion takes place.
Keep in mind, though, that if you decide to split your tax payments, it will add to your income in those tax years. "Make sure you adjust your withholding to account for that accompanying added tax liability. Or you can make estimated tax payments in 2011 and 2012 so that you won't incur any underpayment penalties," says Kay Bell, Bankrate's contributing tax editor and author of "The Truth About Paying Fewer Taxes."
Another thing to keep in mind: On Jan. 1, 2011, the tax cuts of the Bush administration are set to expire. That means that unless Congress acts, the 10 percent rate will also disappear and the top rate will go to 39.6 percent. "While lawmakers likely will keep the lowest 10 percent tax bracket, President Obama has indicated that he will let the rate rise for higher income earners," says Bell. "If you are likely to be in that tax bracket, you might want to reconsider deferring your IRS conversion taxes."