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Most of you are familiar with the 401K plan and the traditional IRA, but recent IRS changes have turned the spotlight on its lesser well-known cousin, the Roth IRA.  Recently there have been changes to allow high income earners to convert to a Roth IRA in 2010.

Before we figure out whether a Roth conversion is a good idea for you, let us first look at some basics.

What is a Roth IRA?

Like a 401K, a ROTH IRA is a vehicle for long-term savings, started in 1997. It is a tax-advantaged account, but unlike the traditional IRA or the 401K, you invest with the money you have left after paying your taxes.

Your money grows tax-free and you do not ever have to pay taxes on it again – yes, even gains and dividends in your Roth are tax free! ,

The main difference is when you pay your taxes. With a ROTH Ira, the tax is incurred upfront. In the traditional IRA or 401K, you have a tax advantage in each year of contribution, and you only pay your taxes on withdrawal when it is taxed like income.

Who is eligible for a Roth conversion?

Previously, you were eligible if you earned an adjusted gross annual income, singly or jointly, of not more than $100,000. That meant high-income earners or dual-income couples were not eligible.

However, the IRS has done away with the income limit, and top-income investors are now able to convert to the Roth. Many of them appear to be rapidly switching, creating a lot of business for their financial advisors and mutual fund companies

The wave of conversions is so strong that there is even an iPhone app to facilitate conversions! Recently published numbers in USA Today show that at the Vanguard Group, January 2010 Roth conversions were 7 times more than what they were in 2009!

What Happens on a Roth conversion?

To swap to a Roth, you need to pay upfront the taxes that were deferred on the income and subsequent investment gains in a 401K or a traditional IRA.

The IRS is making it easy for you by giving you a one-time chance to pay your tax bill over three years from 2010 till 2012.

Should You Convert to a Roth IRA?

There are many variables to consider. Some people are doing Roth conversionso because the depressed markets in the past few years have eroded gains in their 401K and the traditional IRAs, and they have therefore much less tax to pay, than if the markets had been booming then.

The question is:  Do you want to pay a big tax bill today or a bigger one tomorrow?

Secondly:  Can you afford to pay the bill, even if there is a three year window to do so?

Another important factor is your age, and how many more years of tax-free earnings you can expect before you need to make withdrawals.

If you are 30 years of age with another 30 years of investment gains, you are more likely to make a different decision from your neighbor who is now 62 and is planning to withdraw his gains to go sailing around the world in the next year.

How to convert to a Roth Ira

High-income earners still cannot directly invest in a Roth Ira. They have first to open a traditional IRA and then convert it to a Roth. The first thing to remember is that you do not have to convert all of your IRAs in one year , you can do it in tranches.

The mechanics of conversion may be a little less simple, especially if you have a few IRA accounts. You cannot pick and choose the accounts you wish to convert.

Here is an example. You have 2 IRA accounts, one worth $60,000 has non-deductible contributions (contributions made from after-tax money) of $20,000, and the other a rollover IRA of $100,000.

You cannot transfer just the non-deductible amount of $20,000 into the Roth. You have to observe the pro-rata rule. Altogether, you have $160,000, and the non-deductible portion accounts for 1/8. If you decide to convert $50,000 into the Roth, the portion that would be tax free is 1/8 of $50,000 or $6,250.00.

One of the issues of conversion is how to pay the taxes due on the amount you convert, and that is going to influence how much and when you are going to convert. It is advisable not to take money out of your IRA to pay the taxes as you are hit with taxes and possibly penalties.

Bear in mind you have two options:

1. Pay the full tax bill when filing 2010 tax returns
2. Defer it over 2011 and 2012.

For many, it is best to convert as early as possible to leverage the amount of time you have for tax-free investment gains.

There is some Roth conversion paperwork to do, but your mutual fund or the financial institution holding your account will have all the information you require.

You will need to let them know if you want the taxes withheld from your IRA or if you plan to pay the taxes yourself. You will also want to name to the beneficiary to your Roth.

There are also couple of words you need to add to your investment vocabulary – recharacterization and reconversion.

Recharacterization of Roth conversion

It is often overlooked that you can undo your Roth conversion. This is a move called recharacterization which is permissible under tax laws. If you convert $10,000 to a Roth IRA and the market tanks after the conversion, you can have a do-over back to a traditional IRA. You will not get your losses back, but you can claim the full amount of $10,000 to calculate your deductions against your taxes.

You can have a re-do up to October of the year following your conversion; if you have already paid taxes on your Roth conversion, you can file an amended return for a refund.

Roth Reconversion

Further, you can reconvert back to a Roth, yet again, but you have to wait either for 30 days after your recharacterization or the next calendar year, whichever is the later. You are also allowed partial recharacterizations or reconversions.

If you plan multiple Roth conversions, you might consider separate accounts to simplify any future recharacterizations.

Should I do the Roth IRA conversion?

Check out this article which covers reasons for and against doing a Roth conversion.

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