Roth IRA: Switch now, pay tax later by jhon o

Roth IRA: Switch now, pay tax later

People with incomes above $100,000 are now eligible to convert to this tax-beneficial IRA. And the new rules have something sweet for lower earners, too.

[Related content: retirement, IRA, 401k, financial planning, retirement planning]

By Kiplinger's Personal Finance MagazineUntil now, only taxpayers with incomes 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 disappeared Jan. 1, though income-eligibility limits on contributions remain in effect. That means that high earners, thanks to the Tax Increase Prevention and Reconciliation Act of 2005, can now hop on the tax-free retirement income gravy train.

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. Upper-income Americans are likely to bear the brunt of future tax hikes. That makes a compelling argument for converting assets in traditional individual retirement accounts, which will be fully taxed when you tap them in retirement, to tax-free Roths.

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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. The five-year rule does not apply to taxpayers older than 59 1/2. Once you reach that age, you can withdraw converted amounts from your Roth without penalty.
If you run through the entire converted amount and begin dipping into earnings before you pass the five-year point, the earnings would be taxed, though no penalty would apply if you're at least 59 1/2.

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No payments for a while

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 out the payments, reporting half of the conversion on your 2011 tax return (due in April 2012) and the balance on your 2012 return (due in April 2013). That gives you a lot of time to come up with the cash to pay your tax. 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.

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The sooner, the better

You 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.

IRAs: Roth versus traditional

And if the Roth's value declines later, there's a way out. You can convert the account back to a traditional IRA -- also known as a recharacterization -- without paying income tax. (See "4 steps to undo a Roth IRA conversion.")You have until Oct. 15, 2011, to make a final decision on any 2010 Roth conversion.

You could hedge your bets

You might divide the converted amounts among multiple Roth IRAs according to asset class. Say your stock funds soar but your bond funds tank. You end up with a bargain tax bill on the winning stock portfolio, and you can recharacterize the losing bond account without a tax liability.

Experts answer money questions

One note of caution: If you convert a large amount of money to a Roth, it could boost your taxable income substantially, and you might need to pay quarterly estimated tax in 2011 and 2012 to avoid an underpayment penalty.

No 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 strapped U.S. government. If Congress were to kill the Roth, existing accounts would likely be grandfathered. Otherwise, lawmakers would face a taxpayer revolt.