Is a Roth IRA in Your Future?

A lot of readers have recently asked about rules governing who can contribute and convert to a Roth IRA. Here are the answers to their most common questions.I know there is an income limit for contributing to a Roth IRA in 2009, but is it true that it will be waived for 2010? And what happens in 2011 and beyond?

Actually, the income limit for contributing to a Roth IRA isn't going away. But starting in 2010, the income limit on converting a traditional IRA to a Roth IRA will disappear.

In 2009, you can contribute to a Roth IRA only if your modified adjusted gross income is $120,000 or less if you are single or $176,000 or less if you are married filing jointly (the contribution amount starts to phase out if you're single and earn more than $105,000, or more than $166,000 if married). Those income limits should increase slightly in 2010 and 2011.

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Right now, you can convert a traditional IRA to a Roth only if your modified adjusted gross income is $100,000 or less (whether married or single), but the income limit for conversions disappears in 2010. That means anyone will be able to convert to a Roth IRA starting next year.

But you don't have to wait until 2010 to hop on the conversion bandwagon. There's a backdoor entry with a reduced price of admission.

You can make nondeductible contributions of up to $5,000 to a traditional IRA this year ($6,000 if you are 50 or older) and convert it to a Roth next year. If your IRA consists of only nondeductible contributions, you will owe taxes only on the earnings when you convert to a Roth.

Why would someone want to go to the trouble of switching to a Roth IRA and paying taxes on the converted amount? The answer is simple: tax-free income in retirement. And with growing concerns that taxes may rise in the future to deal with ballooning budget deficits, the prospect of tax-free income is looking better than ever.

If I convert to a Roth IRA, when do I pay the tax?

Normally, you pay the tax when you file your return the following year. But there is a special rule for those who convert in 2010: You can split your tax bill on your 2010 Roth IRA conversion between your 2011 and 2012 tax returns.

My IRA contains both deductible and nondeductible contributions. How will my conversion to a Roth IRA be taxed?

If your IRA holds both deductible and nondeductible contributions, only a portion of the converted amount-whether you convert the entire IRA balance or just part of it-will escape taxes.

For example, say your traditional IRA contains $50,000, of which $40,000 represents tax-deductible contributions and $10,000 is after-tax contributions. When you convert to a Roth, only one-fifth of any amount you convert will be tax-free. The remainder is taxed at your regular tax rate. And no, you can't cherry-pick and convert only the after-tax money to a Roth IRA.

I turned 70½ this year but will not need to take my first required minimum distribution because of the congressionally approved waiver for mandatory distributions in 2009. Can I take a distribution anyway and transfer it to my Roth IRA this year?

Yes. In fact, that's a great strategy for shifting some of your traditional IRA money into a Roth IRA (as long as your income is $100,000 or less in 2009). And now could be a particularly good time if your account, like most others, has lost value due to investment losses. The smaller your IRA balance, the lower your tax bill.

You'll still have to pay taxes on the converted amount, but once the account has been open at least five years, you'll be able to take tax-free withdrawals from your Roth IRA, and you'll never have to take required minimum distributions. Your heirs will thank you, too, because Roth IRA distributions are also tax-free to them.

What if I already converted to a Roth and my account value has since declined? Am I stuck paying taxes on the higher balance?

Not necessarily. If you converted a traditional IRA to a Roth in 2008, you have until October 15, 2009, to undo your conversion in a process known as a recharacterization. Ask your IRA custodian to recharacterize your conversion by putting your money back into a traditional IRA. Then you won't owe taxes on the original conversion. Later, you can convert the traditional IRA to a Roth again and pay taxes on the smaller amount.

You have up to six months after the due date of your tax return to undo a Roth conversion. That means October 15, 2009, is the cutoff for conversions made in 2008, and October 15, 2010, is the deadline for conversions made in 2009.

If you recharacterize a 2008 contribution now but have already paid taxes on the original conversion, you can file an amended return to get your money back.

For details, see IRS Publication 590, Individual Retirement Arrangements.