The best and worst candidates for this maneuver, and details on how it works.
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By Christine Benz | 02-22-10 | 06:00 AM | Email Article

Investors of all income levels are now able to convert their traditional IRA assets to Roth IRAs as of the beginning of this year. The opportunity to take tax-free withdrawals on IRA investments certainly holds appeal, but a conversion isn't for everyone. Investors should check with a tax specialist to ensure that they've considered the ramifications--including the potential tax liability--before converting.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Here are some common questions related to IRA conversions, along with the answers.

What's changing in 2010?

Two things. First, income limits on conversions have been lifted, so now anyone can convert from a traditional IRA to a Roth. Second, those who convert in 2010 will be able to spread the taxes associated with the conversion over two years--2011 and 2012.

Is the change permanent or only for 2010?

Income limits are permanently lifted beginning in 2010. However, the special tax treatment (splitting the tax hit over 2011 and 2012) is available only for conversions made in 2010.

What are the benefits of converting?

There are two key benefits. First, Roths offer tax-free withdrawals in retirement, whereas withdrawals from traditional IRAs are taxed as ordinary income. Second, Roths don't require you to take distributions during retirement, so if you don't need the money you can let the assets accumulate for your heirs.

Who is a good candidate for conversion?

In general, younger people are better candidates for conversion than are older investors who are close to retirement or already retired. Those who have the cash on hand to pay the taxes associated with the conversion are also much better candidates for conversion than those who will need to tap the IRA assets to pay the tax. Investors who have a lot of assets in traditional 401(k)s and IRAs may also benefit from a conversion because it will diversify the tax treatment of their in-retirement withdrawals. This article details who might be a prime candidate for conversion and Morningstar's IRA Calculator can help you crunch some numbers.

Who should think twice about converting?

A conversion will tend to be less attractive for older investors who are well into retirement; they won't have the chance to recoup the tax hit. Conversions are also usually a bad idea if tapping the IRA assets is the only way to pay conversion-related taxes. Finally, conversions won't generally make sense for those who haven't saved much for retirement and will therefore be in a lower tax bracket in retirement than they are now. This article discusses who should think twice about converting.

Are the income limits for starting a Roth from scratch going away in 2010, or is conversion the path for investors whose income is over the limit?

The income limits to open a Roth IRA are still in place; individuals with incomes of more than $120,000 who can also contribute to a company retirement plan can't open a Roth; the threshold goes up to $177,000 for married couples filing jointly. However, individuals whose incomes are over those limits can take a backdoor way into a Roth, opening a traditional nondeductible IRA, then converting soon thereafter. They'd owe taxes on any investment earnings at the time of the conversion. This strategy doesn't make sense, however, for those with substantial traditional deductible IRA assets because the taxes associated with the conversion will be based on the breakdown between deductible and nondeductible contributions in the IRA. Check with a tax advisor before opening a "backdoor IRA" because some advisors are concerned that Congress could close this loophole.

Can I roll over a regular 401(k) into a Roth IRA directly?

Yes, assuming you no longer work for the company where you amassed the 401(k). In this case, the rollover functions almost exactly like a conversion; you'll owe taxes on your deductible contributions and investment earnings at the time you convert.

Will I owe taxes because of the conversion?

It depends. If you've made only nondeductible contributions and you don't have any investment earnings in the account, you won't owe taxes upon conversion. If, however, your IRA consists of deductible contributions, rollover assets from a traditional 401(k), and investment earnings--or some combination thereof--you'll owe taxes when you convert.

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