You might have heard about a one-time opportunity to convert your traditional IRA to a Roth IRA. Although the one-time opportunity to spread the tax consequences of a Roth conversion over two years ended on Dec. 31, 2010, you can still convert your traditional IRA to a Roth IRA at any time, no matter how much you earn. Better still, the IRS gives you plenty of time to you change your mind.
If you want to convert your traditional IRA to a Roth IRA, you must complete your conversion by Dec. 31. This can be confusing, since you can contribute for a given tax year until April 15 of the following year. For example, if you make a contribution to your traditional IRA in February of 2011 for the 2010 tax year, it will be too late to convert that amount to a Roth IRA for 2010.
Unless you made nondeductible contributions to your traditional IRA, you will pay income taxes on the dollars you convert to a Roth IRA. Not only can the additional income bump you into a higher tax bracket, but the timing of your conversion could affect income-related benefits such as college financial aid or Medicare. The IRS warns that you might have to increase your withholding or even make estimated tax payments when you convert.
Because of these tax consequences, you might think it best to withhold a portion of your Roth conversion for taxes. Although the IRS allows this, it will consider the portion that you withhold to be an early withdrawal (unless you are over the age of 59 1/2) and apply a 10 percent tax penalty. This penalty will be imposed in addition to the income taxes you will owe on the amount withheld.
If you convert your traditional IRA to a Roth IRA by Dec. 31 and then realize in February that the tax consequences will be too onerous, you can change your mind. The IRS allows you until Oct. 15 to "recharacterize" your Roth conversion back to your traditional IRA without taxes or penalty. You can also choose to convert only a portion of your traditional IRA to a Roth, reducing your tax liability accordingly.
As of 2010, the IRS removed the restrictions that prevented people earning more than $100,000 to convert their traditional IRAs to Roth IRAs. However, just because you can convert doesn't mean you should. Income tax rules are complex, so check with your broker and your tax professional about your particular situation.