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Three Ways to Pay for a Roth IRA Conversion

Nancy Mann Jackson, Bankrate.com

Thanks to new rules that go into effect in January 2010, for the first time ever, every American with an IRA can qualify for conversion to a Roth IRA, creating the opportunity for tax-free growth of their retirement investment dollars. But converting a traditional IRA to a Roth is considered a taxable event, which means you'll owe taxes on the money that is converted, less any nondeductible contributions made to the Traditional IRA.

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If you're considering converting IRA assets to a Roth, first determine how you'll pay the associated taxes.

Part of the good news about Roth conversion is that the new 2010 rules include an option to spread the taxes out over two years, paying half each year. "If you convert in 2010, you'll have until tax year 2012 to pay all the taxes, which means you won't have to finish paying them until April 2013," says Greg McBride, senior financial analyst at Bankrate.com. "If you make the conversion in January 2010, you'll have 27 months to pay the first half and 39 months to pay the second half." While the new Roth eligibility rules are permanent, 2010 is the only year when taxes can be paid in two subsequent tax years; after 2010, all taxes will be due during the tax year in which the conversion takes place.

Keep in mind, though, that if you decide to split your tax payments, it will add to your income in those tax years. "Make sure you adjust your withholding to account for that accompanying added tax liability. Or you can make estimated tax payments in 2011 and 2012 so that you won't incur any underpayment penalties," says Kay Bell, Bankrate's contributing tax editor and author of "The Truth About Paying Fewer Taxes."

Another thing to keep in mind: On Jan. 1, 2011, the tax cuts of the Bush administration are set to expire. That means that unless Congress acts, the 10 percent rate will also disappear and the top rate will go to 39.6 percent. "While lawmakers likely will keep the lowest 10 percent tax bracket, President Obama has indicated that he will let the rate rise for higher income earners," says Bell. "If you are likely to be in that tax bracket, you might want to reconsider deferring your IRS conversion taxes."

You don't have to defer taxes -- you can pay all the taxes in 2010 if you wish. Ask your tax adviser to run the numbers to see which way will cost you less taxes.

Where will you find the funds to pay the taxes associated with converting to a Roth? Consider these three options.

Pay taxes with the IRA's assets
Some IRA owners simply use assets from the IRA to pay the taxes on the conversion. This may be the only option if you have no other resources, but a large deduction can also severely set back your IRA's potential growth." Using the IRA to pay the taxes defeats the purpose of conversion," McBride says. "The whole idea of converting to a Roth is to turbocharge your future returns because you don't have to worry about taxes."

Most financial experts advise against using assets from the IRA to pay the taxes, as it can take years to replenish those funds. "Depending on your age, it would be unlikely that you or your heirs would recoup assets from the IRA if you use them to pay the taxes," says Marcia Mantell, owner of Mantell Retirement Consulting in Needham, Mass. "If you are under age 59½, you'll lose another 10 percent of the IRA money (that portion used for taxes) to an early withdrawal penalty. While that doesn't sound like much, it is a significant amount to have to rebuild in your account."

Next: How to pay for the conversion....