When you retire, you may roll over an employee-sponsored retirement account, such as a 401(k) or a 403(b), into an individual retirement account (IRA). You would then have your retirement funds in a “traditional” IRA. A traditional IRA also may be composed of direct contributions made by you and the earnings on those contributions.

Whenever you withdraw pretax money from a traditional IRA, you must pay income tax on it. But instead, you may be able to convert all or part of your traditional IRA into another kind of account called a Roth IRA. Or you can make a rollover from a 401(k) or 403(b) to a Roth IRA.

Advantage: You’ll pay tax now on the amount you convert, but from then on, that money and all the earnings on it will be tax free, even when you withdraw it.

Strategy: As long as you’re not planning to tap your IRA right away, a Roth IRA conversion probably makes sense. But knowing the fine points can help you make such a conversion less taxing and potentially more rewarding.

DEFINING THE DIFFERENCE

Typically, most or all of the money in a traditional IRA has never been subject to income tax. As a result, withdrawals are completely or mainly taxable. (If you have made some contributions with after-tax dollars, a corresponding fraction of each withdrawal will be tax free.)

In comparison, Roth IRA withdrawals may escape income tax altogether.

How it works: At any time, you can withdraw the amount that you have contributed to a Roth IRA without owing income tax. Earnings also may be withdrawn, tax free. Required: Roth IRA earnings can be tapped, tax free, five years after the beginning of the year for which you open a Roth IRA. For example, if you contribute to a 2007 Roth IRA on April 15, 2008, the five-year period starts on January 1, 2007—so fully tax-free withdrawals (as long as you are at least age 59½) can begin on January 1, 2012.

Example: Al Jones opens a Roth IRA on December 10, 2008. By year-end 2011, he has contributed a total of $10,000 and has $11,200 in the account, including earnings.

At that point, Al can take out $10,000 without owing tax.

Trap: If Al withdraws the entire $11,200, he will owe income tax on the $1,200 in earnings because the five-year mark hasn’t been reached. He also may owe a 10% penalty on that $11,200 if he is younger than 59½.

Loophole: On January 1, 2013—a little more than four years after he opened the account—Al can take out the earnings, too, tax free, if he is at least 59½.

The “five-year clock” starts at the beginning of the year a Roth IRA is established, so if you open your Roth IRA late in the year, it may take only a bit more than four years to satisfy this requirement.

PAYING THE PRICE

Converting a traditional IRA to a Roth IRA can be quite expensive, tax-wise.

Example: Jan Brown retires with $500,000 in her 401(k). All the money came from salary deferrals and employer matches, so none of those dollars has been taxed. She rolls her $500,000 401(k) balance to a traditional IRA. This maintains the tax deferral.

Next step: If Jan wishes, she may be able to convert her traditional IRA to a Roth IRA.

Required: In 2008 and 2009, Jan’s adjusted gross income must be no more than $100,000, on a single or joint tax return, in order to do a Roth IRA conversion. Starting in 2010, there will be no income limit.

Trap: If Jan converts her $500,000 traditional IRA to a Roth IRA, she will have to pay tax on $500,000 in taxable income for the year of her conversion. Counting federal, state, and local tax, the tax bill for the conversion might be more than $200,000.

THE LONGER THE BETTER

The big question is, when does it make sense to pay such a steep up-front cost for future tax-free cash flow?

If you plan to tap your IRA for living expenses within the next three or four years, a Roth IRA conversion doesn’t make sense. You’ll pay income tax sooner than you need to without gaining much or any benefit.

If you expect to wait 10 years or more after the conversion before tapping your IRA, a Roth IRA conversion probably will pay off.

Assuming an investment return on your account of around 7% a year, your Roth IRA will double in 10 years. Over longer periods of time, the buildup will be much greater because of compounding—your earnings will produce gains, too.

In between: Suppose you plan to tap your IRA in, say, five or six years rather than 10 or more. A Roth IRA conversion may still be a shrewd move because you’ll have those years for tax-free growth. One tactic is to convert some of your traditional IRA to a Roth IRA, but not the entire amount. A partial conversion will reduce your up-front tax bill yet still position you to receive some tax-free income later.

Eliminating the uncertainty: One great puzzle in retirement planning is predicting future tax rates. Current rates will expire after 2010 without a law change to keep them. Also, they may have to go up for the federal government to keep Medicare and Social Security solvent. For Roth IRA owners, future tax rates won’t matter. You’ll know that you can tap this account throughout your retirement without owing income tax.

WINNING THE END-GAME

Roth IRA conversions are especially appealing if you don’t expect to have to tap your IRA in retirement at all, or if you anticipate making only modest withdrawals.

Loophole: Unlike with a traditional IRA, there are no “minimum required distributions” after age 70 ½ from a Roth. The account can keep growing indefinitely. Because of this, your beneficiaries may enjoy years or even decades of tax-free withdrawals. A $500,000 Roth IRA conversion, for example, might generate millions of dollars, tax free, for your heirs.

Planning pointer: Roth IRA conversions work best if the tax bill is paid from funds outside of your IRA. That will leave the account intact for maximum tax-free buildup.

If paying the tax with outside funds presents a challenge, consider a series of partial conversions.

If you convert, say, $50,000 worth of a Roth IRA each year, you will pick up $50,000 of extra taxable income and owe perhaps $15,000 (assuming a 30% tax rate) each year. As long as you can pay that tax with other funds, the Roth IRA won’t be diminished.

A series of relatively small partial conversions may help you keep the tax bill in a lower tax bracket.

Another pointer: Converting from a 401(k) to a Roth IRA via a direct rollover avoids the 20% withholding tax otherwise applicable to plan distributions.

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