Bankrate's 2010 Tax Guide
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Plan for taxes due on a Roth IRA conversion

TAX TIP No. 42

Roth individual retirement accounts don't offer an immediate tax savings as do some traditional IRA contributions. Rather, the taxed money you put in a Roth grows tax-free and you owe Uncle Sam nothing when you withdraw the funds as long as you're at least 59½ and have had the account for at least five years.

Many people, however, haven't opened a Roth.

Some prefer the immediate tax deduction that a traditional IRA offers at filing time.

Others weren't able to open a Roth IRA because they made too much money. You can't contribute the full amount to a Roth if, as a single filer in 2009, you made more than $120,000; the threshold for joint filers last year was $176,000. In 2010, the $120,000 cap remains for single taxpayers, but the couples' earning limit is now $177,000.

There also was a $100,000 income limit that prevented individuals from converting a traditional IRA to a Roth account. Now that limit is gone. Regardless of income, anyone can turn a traditional IRA into a Roth.

Even better, any 2010 rollover from a traditional IRA to a Roth gets special tax treatment. Any taxable income included in the rollover doesn't have to be reported on 2010 taxes. Instead, you can include that money as income in equal amounts in 2011 and 2012 and pay associated taxes when you file those tax returns.

In this tax tip:
  1. Is converting worth it?
  2. Predicting the tax future.
  3. Expiring tax rates.
  4. Conversion mechanics.

Decide if converting is worth it

The first step in moving your old IRA money into a Roth is determining whether it's the best move. You need to ask yourself a few key questions.

What is your time frame? Generally, it makes less sense for older individuals to convert a traditional IRA to a Roth. The reason for that usually is related to the next question.

Do you have cash on hand to pay any conversion taxes? When you convert a regular IRA to a Roth account, you'll owe taxes on the original account's earnings and pretax contributions. This tax bill is at your ordinary income tax rate; there is no capital gains break for IRA distributions.

If you must take money out of your IRA to pay those taxes, you'll put a dent in your retirement account's compounding power. Plus, if you're younger than 59½ you also will owe a 10 percent penalty on the converted amount. Essentially, raiding your IRA to pay conversion taxes (and penalties) could offset the possible future gains of tax-free Roth distributions.

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And don't try to avoid conversion taxes by moving only nondeductible money from your traditional IRA. Once funds are in the account, the IRS considers the money blended, meaning you can't separate deductible and nondeductible amounts.

Finally, don't forget about other tax breaks. Do you qualify for tax benefits that are based upon your income? Many tax benefits are reduced or eliminated altogether when you make over a certain amount. Will you still be able to claim them after you add the traditional IRA money to your income during the conversion to a Roth account?

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