But if you pay taxes on a conversion at a higher rate than you would have owed ontraditional IRA withdrawals, it does take time for tax-free earnings to overcome thatdisadvantage. Just how long depends on the difference in tax rates and the performanceof your investments, so making the switch may not make sense.
Myth 2: Reporting income from a conversion will wipe out any chance your childwill get college financial aid.
Sure, colleges take a close look at your tax return when calculating how much help togive your kids. But aid administrators aren't idiots, and they have the leeway to ignore ananomaly -- such as a Roth conversion -- that makes you look richer than you really are.So be sure the college knows what's going on. If you're covered by Medicare, though,you are in a bind. A conversion-induced income spike could indeed push up your
Part Bpremium for the following year.
Myth 3: This is the only year you get the chance to spread Roth conversion taxesover more than one year.
Although 2010 is the only time you can pay nothing in the year of the conversion -- andthen pay the tax in equal shares the following two years -- there's nothing to stop youfrom gradually converting regular IRAs to Roths over any number of years you choose.For example, if you convert $500,000 in equal chunks over five years, you'd report$100,000 each year and spread the tax over five years, too. Just remember that the sooner the money is in the Roth, the sooner earnings are tax-free rather than simply tax-deferred.
Myth 4: After you convert, you can't touch your money for five years.
This canard grows out of a widespread misunderstanding of the admittedly convolutedway Roth withdrawals are taxed. To withdraw earnings from a Roth tax-free, it is truethat the account must have been open for at least five years. But earnings are the lastthing to come out of a Roth.The IRS assumes that the first money withdrawn comes from annual contributions youmade (and this money can be tapped tax- and penalty-free at any time). Next, you dip intoconverted amounts (always tax-free -- and penalty-free, too, if you are older than 59 or the account has been open for at least five years). Only after you retrieve all of your contributions and converted amounts do you touch earnings -- and if at least five yearshave passed, the earnings are tax- and penalty-free. So, if you convert $100,000 today,you can withdraw it all tomorrow tax-free. The 10% early-withdrawal penalty disappearsonce you reach age 59 or the account has been open for five years, whichever comes first.
Myth 5: You can't spread the tax bill over three years by reporting part of aconversion in 2010 and the rest in 2011 and 2012.
Well, yes you can, if you're married and both husband and wife convert. The law givestaxpayers who convert this year a choice: Report and pay tax on 100% of the conversion