How do you calculate how much money will be taxed when you make the conversion?
The calculation is easy if you've made only tax-deductible contributions. In that case, you'll have to pay taxes on the entire balance when you convert a traditional IRA to a Roth IRA. But the money can grow tax-free. If you've made both tax-deductible and nondeductible contributions to your traditional IRAs, then your tax bill will be based on the ratio of nondeductible contributions to the total balance in all of your traditional IRAs. If your total balance is $100,000, for example, of which $20,000 represents nondeductible contributions, then 20% of any conversion would be tax-free.
When do you have to pay the tax bill?
If you convert your traditional IRA to a Roth in 2010, you can spread the tax bill over two years. You report the first half of the conversion on your 2011 tax return (which you file in April 2012) and the balance on your 2012 return. If you're moving a large amount of money, however, you may want to start making quarterly estimated tax payments in 2011 to avoid an underpayment penalty.
The income limit for Roth IRA conversions is permanently eliminated, but the special opportunity to spread the tax bill over two years applies only to conversions made in 2010.
It's worthwhile to make the switch only if you don't have to tap the IRA for cash to pay the taxes. So even though you have a while before the taxes are due on the conversion, you may want to start setting aside some money over the next year or so to cover the tax bill.
What happens if you convert the traditional IRA to a Roth but then discover you don't have enough money to pay the tax bill? Or what if the account goes down in value after you make the switch?
You'll get a chance to change your mind. If you roll over your traditional IRA to a Roth in 2010, then you'll have until October 15, 2011, to "recharacterize" your conversion and switch the account back to a traditional IRA. You can then reconvert the traditional IRA to a Roth later -- you must wait at least 30 days and until the next calendar year to convert it again. You may end up with a smaller tax bill if your account value has shrunk since your original conversion.
Do you need to have earned income to convert a traditional IRA to a Roth?
No. Although you need earned income to contribute to an IRA, you don't need it to convert a traditional IRA to a Roth.
By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance
