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7 steps to a 2010 Roth IRA conversion

Retirement Guide: Senior man standing by clear lake and mountains
Highlights
  • The IRS offers a 3-year window in 2010 to pay taxes on a Roth conversion.
  • The IRS is letting tax payments on a conversion to be made in 2011 and 2012.
  • Figuring out the tax due on a Roth conversion is not that complicated.

If you have funds in an individual retirement account, converting them into a Roth IRA in 2010 presents an unprecedented opportunity to sock away tax-free retirement income.

The IRS is even offering taxpayers a three-year window in 2010 to pay taxes due on a conversion and is removing income limits that have kept higher-income taxpayers from setting up Roth IRAs.

Many taxpayers have been able to convert their traditional IRAs to Roth IRAs since Roth IRAs were created in 1998. However, income limits and other restrictions have kept many taxpayers from converting. If their modified gross income is more than $100,000, they haven't been able to convert. But in 2010, they'll get their first opportunity.

Roth IRAs differ from traditional IRAs in several crucial ways. While you don't get a tax deduction for making a contribution to a Roth IRA, those contributions grow without taxes and you don't have to pay any tax upon withdrawal in retirement. In addition, Roth IRAs aren't subject to the same minimum distribution requirements that traditional IRAs are, so you don't have to begin withdrawals from your Roth IRA at age 70½.

And because most retirement accounts took a heavy beating in the stock market in 2007 and 2008, and still haven't recovered, the taxes due on a conversion are less than they would be had the market risen, making the case for conversion even more compelling, says Dave Sadler, a certified public accountant and Certified Financial Planner with Moneta Group, a wealth management firm in St. Louis.

If that's not enough, the IRS is allowing taxpayers a one-time opportunity to spread out the payment of taxes due on a Roth conversion in 2010 over 2011 and 2012.

Taxes are due on a Roth conversion because you get a tax deduction on your initial contributions to most traditional IRAs, so you must pay the taxes due on those initial contributions and any growth in your IRA. Your tax bill on conversion also depends on a number of other factors, including your income, your federal tax bracket and your state tax rate.

Roth IRA conversions don't make sense for everyone, but it's worth investigating to decide whether it makes sense for you.

"The issue comes down to what your tax situation is in the year of conversion versus what it might be in retirement," Sadler says. "It's a hard thing to know for sure, but I would say it makes the most sense for younger taxpayers who will have their income grow over time."

Step 1: Evaluate your IRA and 401(k)

First, you need to get a handle on what assets you've got that are eligible for conversion into a Roth. Generally, any assets that you hold in a traditional IRA, whether they are deductible or nondeductible, are eligible. Nondeductible IRA contributions are not taxed when you make a conversion, although earnings from those contributions are taxed.

7 steps to a Roth IRA conversion
  1. Evaluate your IRA and 401(k).
  2. Seek advice if you're unsure.
  3. Weigh financial and tax factors.
  4. Calculate the potential tax due.
  5. Decide when to pay the tax bill.
  6. Consider when to convert.
  7. Fill out conversion paperwork.

If you have a 401(k) or 403(b) from a former employer, you can directly convert those assets into a Roth IRA.

The higher the balance in your IRA or IRAs, the higher your tax bill will be if you convert. However, if you invested aggressively in the stock market and your account value is still down from two years ago, you won't owe as much in taxes as you would have if the account total had been higher, says Brent Lindell, a certified trust and financial adviser with Savant Capital Management in Rockford, Ill.

Under IRS rules, you have to consider the entire value of all of your IRAs when converting and figuring taxes on the conversion, if you have nondeductible IRA contributions.

"(In that instance,) even if you don't want to convert the entire balance of all of your IRA accounts, whatever percentage you want to convert has to include assets from all of your IRA accounts," Lindell says.

For example, if you have four traditional IRAs worth $100,000 and those accounts included nondeductible contributions, but you only want to convert $50,000 of those assets (all from one IRA), the IRS won't allow you to convert only the assets that lost money. You have to take assets from all of your IRAs, not just the losing ones.

So if you have four IRAs, you can't convert two and leave the other two alone. You have to take proportionally from each IRA account.

However, you can convert any IRA accounts or make a partial conversion from one or more of them, if your contributions were all tax deductible.

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