Not only are you permitted to rollover a qualified IRA plan distribution to another plan or to a traditional IRA, but you may also rollover the distribution to a Roth IRA. If you choose this option, however, you are technically converting the rollover IRA assets to a Roth IRA and all of the usual rules for Roth IRA conversions will apply. Specifically, you must be eligible to make the conversion in the first place. If you are, then you must pay income tax on all the pre-tax money that is transferred out of your employer’s plan into your Roth IRA. And you must pay it in the year of the conversion. There is one exception to this rule for conversion that takes place in the year 2010. You are permitted to spread the income from the IRA conversion over two years, beginning in 2011 (half in 2011 half in 2012). For conversions after 2010, however, all of the income from the rollover IRA conversion must be included on the tax return for year of conversion.

Who is Eligible?

For the year 2009, you are eligible to convert rollover IRA to a Roth IRA. If your modified AGI is $100,000 or less, and if you are married, you must file a joint return with spouse. (In other words, those who are married filling separately do not qualify to convert rollover IRA plan assets to a Roth IRA.) Beginning in 2010, everyone qualifies to converting rollover IRA to a Roth IRA.

Which Distributions Are Eligible?

As is the case with rollovers to other plans to traditional IRAs, all distributions and partial distributions from qualified IRA plans and qualified annuities are eligible to be rolled over to a Roth IRA, with the exception of required distributions and annuities or periodic payments that last for ten years or more.

Advantages and Disadvantages

Once you make the decision to roll over your employer’s plan into an IRA, the next question you must ask yourself is traditional IRA or Roth IRA? The decision involves a variety of factors. The beneficiary must first qualify to convert rollover IRA assets to a Roth IRA, the transfer from a qualified plan to a new Roth IRA must occur as a trustee-to-trustee transfer. The disadvantage of converting rollover IRA to a Roth IRA is that you must pay tax on the entire amount of the distribution right away.

When you hear the phrase “tax law changes,” you probably aren’t expecting good news.  However, if you’re considering a rollover IRA/Roth IRA conversion, these tax law changes may actually be to your advantage.

One of the biggest tax law changes in 2010, as far as traditional IRA/Roth IRA rollovers and conversions are concerned, is the ability to pay any Roth IRA tax incurred in 2010 during the conversion process in two parts.  To take advantage of this benefit, you report half of the amount converted during 2011 and pay taxes on it in that year, and then report the remaining half of the account balance during the 2012 tax year.  Spreading out the taxes over two years certainly helps to lessen the Roth IRA tax burden you’ll incur during the rollover/conversion process.

If for some reason the trustee of your current IRA is unable to perform a Roth IRA transfer, then the funds will have to be issued to you.  If this happens to you, understand that you have a limited amount of time to get that money into the target Roth IRA (typically 60 days, according to IRS statutes).  Fail to do so – even by one day – and the IRS will assume that you’ve simply withdrawn your money and will stick you with a variety of taxes and penalties.  For this reason, it’s a good idea to inquire about a direct rollover with both your current IRA trustee and your target Roth IRA trustee to make sure that this type of transaction can occur.

Here’s another tax consideration to make if you’re contemplating an IRA/Roth IRA conversion or rollover – where will you get the money to pay the taxes that are due?  Ideally, you’ll want to avoid using the money from your IRA to pay the taxes due, as this lessens the amount of money you have to invest.  Remember, you’re counting on these funds to grow over time to support you once you reach retirement age.

However, does it make sense for you to use money from your savings?  Will the money you lose in interest income by reducing the amount of your savings be offset by the gains of your money in the Roth IRA?  This is a question that deserves careful consideration.  Your tax accountant or financial adviser can help you put pencil to paper and come up with a real picture of just how much money is involved and how these decisions will impact your financial outlook, both in the short term and in the long term.

First consider the question of taxes.  If you move money from a traditional IRA to a Roth IRA conversion account, you will be required to pay taxes on the money coming out of the traditional IRA structure.  Your investment counselor or tax adviser can help you determine how much those taxes will be.  If you’re thinking about setting up a conversion account, you must consider whether or not you can afford those taxes at this time, as well as whether or not it’s worth it to perform the Roth IRA conversion.  There may be a more advantageous time for you to pay those taxes.

However, if the final tax bill your expect to receive as a result of your Roth IRA conversion scares you, don’t worry.  The new legislation described above offers you the opportunity to split up this tax burden over time in order to minimize your out-of-pocket expenses.  According to the new Roth IRA rules, the taxes you owe on any conversions made in 2010 can be broken up over the next two tax years.

It’s also important to consider the timing of your proposed Roth IRA conversion.  How long do you have before you anticipate beginning to make withdrawals?  The longer your money remains in the conversion account, the greater the benefits of making the conversion, generally speaking.  A minimum of five years is recommended by some financial counselors in order to make up the cost of the taxes you’ll owe.  Otherwise, you may want to consider another type of IRA, rather than a Roth IRA conversion.

In some cases, though, one of the best reasons to establish a Roth IRA conversion account is – strangely enough – the opportunity to pay taxes on your money now.  While most people anticipate being a lower tax bracket once they retire, that may not be the case for you.  If you anticipate being in a higher tax bracket upon retirement, it makes sense to set up your rollover account and pay those taxes now.  Or, if you plan to leave your savings to your beneficiaries or heirs, it may be advantageous to your estate to pay taxes now.  Again, these considerations can be complex, and are best made with the advice of a financial professional.

When you’re setting up your Roth IRA conversion account, make sure you understand all of the tax implications involved in your transfer.  If you’re ready to go ahead, your next step is to establish a Roth IRA with a provider who is well rated and provides excellent customer service.  Make sure the Roth IRA is set up so that it can receive the funds before initiating the rollover request. T o minimize any potential tax liabilities, penalties and withholding, talk with your Roth IRA account manager or trustee about performing a direct rollover or trustee to trustee transfer when moving your funds into the account.

Step 1 – Open a Roth IRA

If you’re at this point in the process, you’ve already rolled your old employer’s 401k or 403b retirement funds into an traditional rollover IRA account, which means you’ve already done the hard work of choosing an IRA account provider and moving your funds out of their original plans.

In most cases, you’ll want to open your Roth IRA account with the same provider that holds your rollover IRA.  This is the easiest course of action, although you may want to change providers if you’ve been unhappy with the customer service or investment options at your current provider.

Whether you decide to stick with your old provider or choose a new one, your first step in the Rollover IRA/Roth IRA conversion process is to open a Roth IRA account.  Typically, all you’ll need to do is fill out a form with your personal information – the provider will take care of the rest.

Step 2 – Fill out the Conversion Paperwork

If you decide to stay with the same IRA account provider, you’ll need to fill out a form they provide that details how the conversion will occur.  You’ll use this form to let the provider know how much of your funds should be converted and whether or not you’d like the provider to withhold any tax from the transfer.  You’ll likely need to have this document notarized and sign your name to indicate that you’ll be liable for the Roth IRA tax.

If you choose to open your account with a new provider, your paperwork may be a little more complicated, since you’ll need to transfer your funds between providers and from a traditional IRA to a Roth IRA.  However, it shouldn’t be that much more complicated than the documentation you completed to move your funds from the original 401k account to your rollover IRA.  If you have any questions, a customer service representative should be able to help walk you through the process.

Step 3 – Select Your Roth IRA Investments

Once you’ve completed the necessary paperwork, your provider will handle the rest of the transaction.  The Roth IRA transfer will take anywhere from a few hours to a week or two, depending on your provider.  After the funds have been deposited into your Roth IRA account, you’ll need to choose your investment options, just as you did with your 401k and rollover IRA accounts in the past.  A qualified financial advisor can assist you if you aren’t sure which options to choose.

In the future, when it comes time to pay taxes on your Roth IRA conversion, you’ll need to watch for mailed statements from your account provider.  Typically, you’ll receive a Form 1099R which shows how much money was converted to your Roth IRA.  This will need to be included on your annual income taxes; otherwise, you could face serious Roth IRA penalties.