Dear Liz: I’ve been contributing to a traditional individual retirement account for the last few years. Taking one of your recommendations, I would like to move the money to a Roth IRA. I understand that I’ll have to pay taxes on the conversion, but will there also be any penalties involved? If so, how much of a penalty? If there is no penalty and only taxes, what is the rate I should be expecting?
Answer: Roth IRAs offer tax-free withdrawals in retirement, which is why they’re a great deal for many savers, and conversions are about to become easier.
Currently there is no penalty for converting a traditional IRA to a Roth, but you will owe income taxes that are determined by your tax bracket. If you’re in the 25% federal tax bracket, for example, you’ll owe taxes equal to 25% of the amount you convert, assuming your contributions were all tax-deductible. (If you made nondeductible contributions, those will reduce the tax bill proportionately.) You’ll also need to factor in state and local income taxes.
You can convert to a Roth this year only if your modified adjustable gross income is $100,000 or less. Next year, however, the income limit on Roth conversions is scheduled to be removed. Also, for 2010 only, you can opt to have the taxable income from your conversion reported in two equal installments in 2011 and 2012, putting off the tax bill you owe.
Make sure you have enough cash to cover the taxes without raiding the IRA you’ll be converting. But being able to put off the tax bill, and paying it over two years, should lessen the burden. Talk to your tax pro for details.