Here's what you need to know about switching a traditional IRA to Roth now that the income limit has disappeared. By Kimberly Lankford, Contributing Editor January 20, 2010 I've been getting a ton of questions from readers about the new Roth IRA conversion rules that took effect this year. Now anyone can convert his or her traditional IRA to a Roth regardless of their income. (Before 2010, you could not make the switch if your adjusted gross income was more than $100,000, whether married or single.) To help you understand how the new rules work, here are the answers to several key questions I've received. SEE ALSO: Beware Peddlers of Roth Conversion Tax Ploys How do I go about converting my traditional IRA to a Roth now that it's 2010? Anticipating a slew of conversions, most IRA administrators will make it easy for you to convert your traditional IRA to a Roth. Some (including Fidelity, Vanguard and T. Rowe Price) also offer handy tools on their Web sites to help you calculate your tax bill before you make the switch. Also see our Should I Convert My IRA Into a Roth IRA? calculator. Advertisement If you're sticking with the same IRA sponsor -- moving money from a Vanguard traditional IRA to a Vanguard Roth, for example -- you can probably do the deed on-line within a few minutes. You'll open a Roth and simply move all or any part of your assets from the old IRA to the new one. You'll be asked if you want taxes withheld from the amount you move to the Roth. (Remember, moving money from a traditional IRA to a Roth triggers a tax bill on the full amount, unless you’ve made nondeductible contributions to the traditional account, in which case part of the conversion is tax-free.) It’s best to say "no to withholding and pay the bill with non-IRA funds. If you dip into the IRA to satisfy the IRS, you'll owe tax on that amount, too, in addition to the funds you're moving to the Roth. And, if you're younger than 59 1/2, you'll also be slapped with a 10% penalty on the money used to pay the tax bill. If you’re switching your IRA from one mutual fund company, brokerage firm or bank to another, things are a little – but just a little – trickier. You'll fill out most of the paperwork with the new IRA administrator, which can walk you through the process. But it's a good idea to give the old firm a heads up so that the transaction will go smoothly. Taxes on conversions How do you calculate how much money will be taxed when you make the conversion? The calculation is easy if you've made only tax-deductible contributions. In that case, you'll have to pay taxes on the entire balance when you convert a traditional IRA to a Roth IRA. But the money can grow tax-free after that (see Why You Need a Roth IRA for details). If you've made both tax-deductible and nondeductible contributions to your traditional IRAs, then your tax bill will be based on the ratio of nondeductible contributions to the total balance in all of your traditional IRAs. If your total balance is $100,000, for example, of which $20,000 represents nondeductible contributions, then 20% of any conversion would be tax-free. Advertisement When do you have to pay the tax bill? If you convert your traditional IRA to a Roth in 2010, you can spread the tax bill over two years. You report the first half of the conversion on your 2011 tax return (which you file by April 15, 2012) and the balance on your 2012 return. If you're moving a large amount of money, however, you may want to start making quarterly estimated tax payments in 2011 to avoid an underpayment penalty. The income limit for Roth IRA conversions is permanently eliminated, but the special opportunity to spread the tax bill over two years applies only to conversions made in 2010. Conversions are most valuable if you don't have to tap the IRA for cash to pay the taxes. So even though you have a while before the taxes are due on the conversion, you may want to start setting aside some money over the next year or so to cover the tax bill. Advertisement What happens if you convert the traditional IRA to a Roth but then discover you don't have enough money to pay the tax bill? Or what if the account goes down in value after you make the switch? You'll get a chance to change your mind. If you roll over your traditional IRA to a Roth in 2010, then you'll have until October 15, 2011, to "recharacterize" your conversion and switch the account back to a traditional IRA. You can then reconvert the traditional IRA to a Roth later -- you must wait at least 30 days and until the beginning of the calendar year after the year of the orginal conversion to convert it again. You may end up with a smaller tax bill if your account value has shrunk since your original conversion. For more information, see Undoing a Roth Conversion. Can I convert just some of the money in my IRAs? You can convert as little or as much as you want. As noted earlier, the tax on amounts converted in 2010 can be paid 50/50 with your 2011 and 2012 tax returns. You can spread the tax bill on conversions over any number of tax years that you spread the conversions over. Converting $100,000 to a Roth via ten, $10,000 annual conversions would spread the tax bill over ten years. Just remember that the sooner your money is in the Roth, the sooner earnings are tax-free instead of just tax-deferred. Advertisement Am I required spread the tax payment on a conversion over my 2011 and 2012 returns, or can I include the income on my 2010 return? You have the option of including all of the conversion income in 2010. This could be a good idea if you're a high earner because the top income-tax brackets are set to rise after 2010, says says Rande Spiegelman, vice-president of financial planning for the Schwab Center for Financial Research (see Lots of Tax Hikes Coming in 2011 for more information). But it's not a simple decision, he says, because including all the income on your 2010 return will increase your adjusted gross income and could affect your eligibility for other tax breaks that have maximum income limits. Plus, your tax bracket could also be bumped to a higher level if you include all of the income in one year instead of over two years-and, if you're older than 65, you might have to pay higher Medicare Part B premiums if your income is above the limit for paying a Part B surcharge. (In 2010, the surcharge applies to individuals with a modified adjusted gross income of more than $85,000 and married couples with a modified AGI of $170,000 or more.) In your column in the January 2010 issue of Kiplinger's,you stated that "if you already have a traditional IRA, you can't simply put $5,000 into a nondeductible IRA and then move it tax-free to a Roth." Please explain again. I had contributed to a deductible IRA for many years, then stopped putting money into that account when I was no longer eligible for the deduction. I make too much money to contribute to a Roth, but I have been contributing to a nondeductible IRA for many years. I want to convert all of this into a Roth in 2010. I also want to contribute to the nondeductible IRA in 2010 and convert it into a Roth because I make too much to contribute directly to a Roth. Why can’t I do this in 2010? My wife is in the same predicament. Now that it's 2010, you can convert your traditional IRAs to a Roth regardless of your income. What I was referring to was the tax treatment of the conversion -- if some of your IRA contributions have been tax-deductible and some have been nondeductible, you can’t just cherry-pick the nondeductible contributions to convert and avoid paying taxes. Instead, the amount taxable on the conversion is based on the ratio of nondeductible contributions to the total balance in all of your traditional IRA accounts. If you have $10,000 in nondeductible contributions, for example, and the total balance is $12,000, then 83% of any conversion would be tax-free. Income limits I know that the income limits for converting a traditional IRA to a Roth will be eliminated in 2010. But will the income limits for contributing to a Roth IRA be eliminated in 2010 as well? No, you still won’t be allowed to contribute to a Roth IRA if your income is above a certain level. But it will be easy for anyone to take a back door into a Roth. For married taxpayers who file jointly, the right to contribute in 2010 to a Roth will phase out as income rises from $166,000 to $176,000. The amount taxpayers who or single or filing as head of household can contribute is phased out as AGI rises from $105,000 to $120,000. But now that the restriction on converting has disappeared, the limit on contributions loses its sting. It’s perfectly legal to contribute to a nondeductible IRA (for which there are no income limitations) and immediately convert that amount to a Roth IRA. Unfortunately, if you already have a traditional IRA, you can’t simply put $5,000 in a nondeductible IRA, say, and then move it tax-free to a Roth. The tax-free part of the conversion is based on the ratio of nondeductible deposits in all your traditional IRAs to the total balance in those accounts (contributions -- deductible or not -- and earnings). The rest of the conversion would be taxed. My wife and I have traditional IRAs that we intend to convert to a Roth. We made the maximum contributions to them in 2009. Can we also make contributions to the IRAs for 2010 before we convert? My income is too high to qualify for Roth contributions. You sure can. Even though there is still an income limit to contribute to a Roth IRA in 2010 -- your modified adjusted gross income must be less than $120,000 if single or $177,000 if married filing jointly -- the $100,000 income limit to be able to convert a traditional IRA to a Roth disappeared in 2010, giving everyone a back door into a Roth. You can now make your contributions to a traditional IRA and immediately convert them to a Roth IRA. I haven't made IRA contributions over the past few years because I earned too much to contribute to a Roth and didn’t qualify to make tax-deductible contributions to a traditional IRA. Now I wish I would have contributed to a nondeductible IRA anyway so that I could have converted it to a Roth. Is there anything I can do to catch up? You still have until April 15, 2010, to contribute up to $5,000 to an IRA for 2009 (or $6,000 if you’re 50 or older). You can also make your contributions for 2010, then convert the money to a Roth. I am 68 with no earned income. Under the new law, can I convert a traditional IRA to a Roth and make contributions from investment income? If so, what are my limitations? You don't need to have earned income to be able to convert a traditional IRA to a Roth. But you do need to have earned income to make new IRA contributions. If you don't work but your spouse does, he or she can make IRA contributions on your behalf. If you and your spouse are both older than 50, you can each contribute up to $6,000 to an IRA in 2010 (although the total contributions cannot be more than your spouse's earned income). You both can contribute to a Roth as long as the adjusted gross income on your joint return is less than $177,000 in 2010 (the maximum contribution starts to phase out if you earn more than $167,000). Roth withdrawals If I'm older than 59 1/2 when I convert my traditional IRA to a Roth, will I be allowed to withdraw all of the money I convert right away without taxes or penalties? Maybe. As soon as you convert, you can withdraw any part or all of the amount moved from a traditional IRA with no additional tax or penalty. (Remember, you pay tax on the converted amount when you make the switch, and because you're over 59 1/2, there’s no penalty.) If you withdraw any earnings from the Roth account before you meet the "five-year test," however, that amount will be taxed. So, when do you pass the five-year test? If the conversion is your first venture into the world of Roth IRAs, you'll pass the five-year test for a 2009 conversion on January 1, 2014 -- the beginning of the fifth calendar year after the year of the conversion. However if you contributed to Roth earlier (or made an earlier conversion), the five-year clock for this test started running on January 1 of the year of that contribution. So you might not have to wait to get at tax-free earnings. If you opened a Roth in 2005 or earlier, for example, you've already passed the five-year test for purposes of tax-free earnings. The IRS considers the first money out of a Roth IRA to be a return of contributions (tax- and penalty-free); next comes a return of converted amounts (always tax-free and penalty-free if you're at least 59 1/2 or the account passes the five-year test); after all such funds have been withdrawn, then any money that comes out is considered earnings, which are taxed if you aren't at least 59 1/2 and haven't met the five-year test. If I'm older than 70 1/2 when I convert a traditional IRA to a Roth, can I avoid taking required minimum distributions on the account? Yes, but not until the year following the conversion. Although RMDs are not required of the original owner of a Roth IRA, an RMD from a traditional account for the year of the conversion must be made prior to the switch. If you have money left in the Roth when you die, your heirs will be required to take RMDs from the account they inherit. On the bright side, that money will be tax-free to them. Can you roll over a 401(k) directly to a Roth? Yes. The tax law changed in 2008 to allow you to roll money directly into a Roth IRA from a 401(k), 403(b), 457 or other tax- qualified retirement plan. (Normally, you must wait to switch jobs or retire before you can move money out of your employer-based retirement account, but some plans permit in-service distributions to workers older than 59 1/2, allowing them to roll over some or all of their 401(k) money into an IRA.) Before the rule changed, you had to do a two-step maneuver: Roll over the 401(k) into a traditional IRA, then convert that account to a Roth. Got a question? Ask Kim at firstname.lastname@example.org.