Roth IRA Conversions: A Comprehensive Guide

A Roth IRA conversion transfers funds from a pre-tax retirement account into a Roth IRA account. Accounts that are eligible for Roth IRA conversions include traditional IRAs, employer qualified pensions, 401(k) plans, annuity plans, tax sheltered annuities, 403(b) plans and government section 457 plans. Roth IRA conversions can be accomplished two different ways. The investor can rollover distributions of funds from his pre-tax plan to a Roth IRA account within 60 days of receipt. Another way to transfer the funds is to instruct the trustee to execute the conversion directly between accounts. 

Taxes

Investors must declare and pay income tax on the entire converted amount in the same tax year as the conversion. Keep in mind that paying the income taxes with a portion of the converted funds could result in a 10% early withdrawal penalty for investors younger than 59 years old. This lump sum income tax requirement has discouraged investors from converting in the past.  

New Tax Incentive

To reduce the impact of taxes, Congress enacted a special tax incentive for 2010 Roth IRA conversions. Basically, they allowed the income generated by the conversion to be spread equally over 3 years, from 2010 through 2012. As of 2010, there are no limit for Roth IRA conversions. Also, there are no limit on the amount of funds which can be rolled over. Investors that earn more than $176,000 annually are still excluded from additional contributions to a Roth IRA.