Roth Conversions

The rules on converting a traditional IRA to a Roth IRA have been relaxed for 2010, opening the door to more taxpayers to make this conversion.

Contributions to a traditional IRA are generally tax deductible. Distributions from a traditional IRA are generally considered to be taxable income.

Contributions to a Roth IRA are post-tax, meaning you get no tax deduction when you make a contribution. However, distributions from a Roth IRA are generally tax-free.

Taxpayers have always been able to convert a traditional IRA to a Roth IRA, but only if their income was less than $100,000. For 2010, the income limitation has been removed. Meaning, anyone can now convert a traditional IRA to a Roth IRA. And, a bill was recently signed into law that allows Roth conversions within 401(k) plans as well.

When you make a conversion, the money in your traditional IRA/401(k) is treated as being distributed to you, so you’ll have to claim it as income and pay tax on it. For 2010 conversions only, you will have the option of claiming half of the amount as income in 2011 and the other half as income in 2012.

Example:
John has $40,000 in a traditional IRA account that he wants to convert into a Roth IRA in 2010. John will have to claim the $40,000 as income on his tax return. He can elect to claim all $40,000 on his 2010 return, or claim $0 in 2010, $20,000 in 2011 and $20,000 in 2012.

The upside to a Roth conversion is that a Roth account will provide you with tax-free income at retirement. That being said, the decision on whether to convert a traditional IRA/401(k) to a Roth account is complex and involves many variables. In general, a Roth conversion is advisable if think you will be in the same or higher tax bracket at retirement, you have a long time to go before retirement, and if you can afford to take the current tax hit. You should consult with both a tax advisor such as me, and your investment advisor, before making a final decision on whether to convert.