A Sweet Deal on Roth IRA Conversions

UPDATE: Since this story was published, questions have been raised about the strategy it discusses . . . of moving only after-tax money from a 401(k) to a Roth IRA. Although it is not crystal clear, it appears that the IRS believes a rollover of a 401(k) to a Roth IRA would be treated the same as a rollover from a traditional IRA to a Roth -- that is, that the amount of the rollover that would be tax-free would be based on the ratio of after-tax and pre-tax money in the 401(k).

Employees who make (or who have made) after-tax contributions to their employer's retirement plan, listen up. You can now take that money and convert it to a Roth IRA tax-free.To qualify for a Roth conversion, your adjusted gross income may not exceed $100,000, whether you are single or married. But don't despair if you make too much now; income limits on conversions disappear in 2010. Income limits on new contributions to Roth IRAs, however, will remain in effect. In 2009, individuals who make up to $120,000 and married couples who make up to $176,000 may contribute up to $5,000 to a Roth IRA, and $6,000 if they are 50 or older.

The new rule on after-tax contributions is much more liberal than the one that governs a conversion from a traditional IRA to a Roth IRA. In that case, the tax-free portion of the rollover is determined by the ratio of nondeductible pay-ins to the total amount in all of your IRAs. So if your $60,000 IRA contains $6,000 in nondeductible contributions and you convert that $6,000 to a Roth IRA, just $600, or one-tenth of the converted amount, would escape income tax. The remaining $5,400 would be taxed at your regular income-tax rate. But under the new rules for after-tax money in 401(k)s -- and 403(b)s and 457 plans -- the full $6,000 would escape taxes. Plus, there is no limit on how much you may convert.

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"It's a sweet deal that lets you move money to a Roth IRA with no tax costs," says Ed Slott, a CPA and IRA expert in Rockville Centre, N.Y. "You can't do that from an IRA."

Not all retirement plans allow after-tax contributions. But if yours is among those that do, this is a great way to keep some of your retirement savings growing tax-free without paying the usual price of admission to convert to a Roth IRA. 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, allowing you to roll over some or all of your 401(k) money to an IRA once you reach age 59½.