What an IRA conversion will mean to the account holder - now and later
My recent column about Roth IRA conversions unleashed a flood of reader e-mails illustrating widespread confusion.
I’ll try clearing them up.
Traditional and Roth IRAs are types of individual retirement accounts. Contributions to traditional IRAs may be tax deductible, but withdrawals are taxed. Roth IRA contributions are never deductible, but withdrawals can be tax-free. Converting a traditional IRA to a Roth offers the potential of future tax-free growth in exchange for being taxed on the conversion.
The conversion itself is merely a paperwork transaction. Your IRA custodian can guide you through it. You may choose to convert all or part of the traditional IRA.
You don’t need “earned income,’’ which is mostly income from work, to convert. You need earned income to make a direct contribution to any type of IRA, but conversions are not the same as direct contributions.
For 2009, you can convert unless your modified adjusted gross income is more than $100,000 or you are married and file separate tax returns. Beginning in 2010, anybody with a traditional IRA can convert.
If your traditional IRA contains nondeductible contributions, they are not taxed on conversion. (If you convert a $100,000 IRA with $20,000 in nondeductible contributions, only $80,000 is taxable upon conversion.) But you cannot “cherry pick’’ and convert just the nontaxable amounts. Instead, you must pay your pro-rata share of taxes.
Converted amounts can always be withdrawn from a Roth IRA without having to pay ordinary income tax (you already paid it when you converted). But converted amounts withdrawn before five years are subject to a 10 percent penalty if you are under 59 1/2 when you make the withdrawal. If you are at least 59 1/2 when you take the money out, however, “there is never a 10 percent penalty on withdrawals, period’’ even if the five-year holding period is not met, said Ed Slott, editor of a national IRA newsletter.
Traditional IRAs impose annual required minimum distributions or RMDs after age 70 1/2. Roth IRAs never do for as long as you live. If you have a traditional IRA and are over 70 1/2, you are not allowed to convert your RMD to a Roth IRA (but you could convert the rest of the IRA and eliminate future RMDs). Since Congress has waived RMDs for 2009, people 70 1/2 and older could convert their entire traditional IRA this year if they qualify for a conversion.
If you convert to a Roth IRA and then change your mind, you can undo or “recharacterize’’ the conversion - another paperwork transaction - up to Oct. 15 of the following year, which is the tax filing deadline for extensions. It is as if the conversion never took place.
To convert again, you would have to wait 30 days or until the calendar year after the initial conversion, whichever comes later.
Humberto Cruz can be reached at AskHumberto@aol.com. 
