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.

For a withdrawal from a Roth IRA to be considered qualified, meaning that you avoid taxes and penalties on the withdrawal, you must meet certain conditions.  A five-year aging requirement is imposed by the IRS, and you must meet one of three additional conditions – you must be at least 59 ½ years old, you must be making a first time home purchase, or there must be a disability or death to you or a dependent.  If you fail to meet these qualifications, taxes must be paid on the earnings withdrawn, in addition to a 10 percent additional tax penalty unless you qualify for an exception according to IRS rules.

While traditional IRAs require you to receive required minimum distributions (RMDs) beginning at age 70 ½, there’s no such requirement with Roth IRAs, except for Roth 401k plans.  As with a traditional IRA, you must begin receiving RMDs from a Roth 401k at age 70 ½ years.  As an additional precaution, be aware that contributions to a Roth 401k IRA cannot be moved to a regular 401k account, as you can’t “un-pay” taxes on the funds in your Roth account.

To continue to reap the benefits of your Roth IRA, consider carefully where and how any withdrawals will be used before they’re removed from your account.  As noted above, there are certain taxes and fees involved with a withdrawal which may make a rollover more advantageous.

Because of the nature of the funds in a Roth IRA, they can only be rolled over into another Roth IRA.  Generally, you would only move funds from one Roth IRA to another Roth IRA if the second offered you some advantage, such as increased earning potential, more control over your money or the ability to consolidate accounts under one provider or adviser, for example.

The rules surrounding Roth IRAs are a little different and a little more complex than traditional IRAs, especially with the legal changes that take effect in the 2010 tax year.  With this knowledge, you may want to consult a tax adviser or your financial planner before you make any decisions about moving money from one Roth IRA to another, or before you consider making a withdrawal.  There may be good reasons for either transaction, but you should confirm your decision with someone better versed in Roth IRA rules before you make decisions that could impact your future and that of your family.

Recently, though, the standards for Roth IRA conversion eligibility have changed.  Starting in 2010, there are no longer any income restrictions on those who are seeking a conversion.  If you have money in a traditional IRA, you can convert it into a Roth IRA, regardless of your household income.  Keep in mind, though, that these limits only apply to Roth IRA conversions – if your income is above certain guidelines, you won’t be able to contribute any additional funds to the account.

If you qualify for the Roth IRA rollover, you can distribute the entire balance of your traditional IRAs into the account without a problem.  The only thing that you’ll need to do is to ensure that you have the appropriate amount of taxes deducted from the IRA to cover your IRS needs – or enough funds on hand to pay your tax bill if you choose to convert the entire amount without withholding any money for taxes up front.

Of course, you might be wondering why anyone would want to open a Roth IRA if they’re just going to have to pay taxes on the amount that they transfer in.  The answer is that, since you don’t have to pay taxes again when the money is withdrawn, all of the earnings that come from a Roth IRA account are tax free.  For those who are worried that taxes are going to increase in the future, a Roth IRA rollover will allow them to invest with less stress.

To protect your 401k rollover to Roth IRA from unnecessary penalties, you’ll most likely want to go with a direct transfer to move your money between accounts.  This is a type of transfer that’s arranged directly between the banks, so that you never see a check for the balance of your account funds.  Doing it this way – instead of through an indirect transfer – will help to ensure that the proper amount for taxes will be withheld and that you won’t end up owing additional funds at the end of the year when you file your taxes.

So, if you’re interested in a Roth IRA distribution from your traditional IRA account and you meet the requirements described above, you should go to your financial advisor or your bank and set up a Roth IRA account.  After this is done, you can then have the bank complete the Roth IRA conversion from your existing account.  If you like, you can even ask them to withhold additional taxes, just to make sure that you’re adequately covered when it comes to taxes and the IRS.

Because of this difference in how taxes are applied to the two types of IRA accounts, you’ll need to be prepared to pay taxes on the amount that you’re moving over if you’re contemplating a Roth IRA conversion.  This can be a confusing task, so to be sure that the IRA to Roth IRA conversion goes well; you’ll probably want to perform a direct transfer so that the bank is responsible for managing the withdrawal of the taxes.  If you’re confused by this, don’t be – it is important that you understand the difference between the two types of transfers so that you can choose the best option for your needs.

The direct transfer mentioned above is a type of transfer that occurs completely between banks.  With this type of Roth IRA conversion, you’ll need to establish the new Roth IRA account, but beyond this, the bank will initiate the transfer of money from your existing account into the new account and will take care of any taxes that need to be reported to the IRS.

The other type of 401k Roth IRA conversion is known as an indirect transfer, and it works a little differently.  In this case, the existing IRA account is closed and a check is issued to you for only 80% of the total balance (the other 20% is withheld for tax purposes).  You then have 60 days total to open the new Roth IRA and deposit the money.  In most cases, the 20% would then be released into the new IRA, but with a Roth IRA conversion, the rules are a little different, which can lead to confusion.

Because of this confusion, many people opt to not complete a Roth IRA transfer from their existing IRA, but rather opt to roll the IRA into another traditional IRA and then open up a separate Roth IRA account to receive new contributions.  This is a possibility, and it can alleviate some of the stress involved with Roth IRA taxes.  This way, the money that you’ve already have set aside in a tax-deferred account is left alone, and you’re free to make future deposits into the Roth IRA account.  Whichever way you choose to go, you’ll need to make sure that the taxes are handled properly, as mistakes here could cause problems later on.

The main characteristic that sets Roth IRAs apart from other IRAs is that Roth IRAs are funded with income upon which you’ve already paid federal and state income tax.  Conversely, most IRAs are funded with income upon which you haven’t yet paid federal or state income tax.  This means that when you rollover to or convert to a Roth IRA, you will be expected to pay income tax on those funds.

The question of how much tax you’ll owe depends on a number of factors, including how much money is involved and what your current tax bracket is.  Bear in mind also that you aren’t required to convert the entire balance of your traditional IRA to a Roth IRA at once – you can convert as much or as little as you choose at a time.  If you have further questions about these requirements, check out the IRS website for more information or, better yet, speak with your personal financial adviser or tax accountant.  He or she can help you to determine exactly how much tax you’ll be required to pay.

Another legal change that takes place in the year 2010 is when the Roth IRA taxes you owe will be due.  If you roll over to or convert to a Roth IRA in 2010, you’ll pay half of the taxes due in 2011 and the remaining half in 2012.  This allows you to spread out the tax burden, which could be a real bonus if you’re considering rolling over or converting a significant amount of money.  Again, your personal financial adviser or tax accountant can help you determine not only exactly how much tax you’ll be required to pay, but also how that will affect your taxes for the years 2010, 2011 and 2012.

Another bit of good news – if you choose to rollover your IRA to a Roth IRA or convert your funds to a Roth IRA, you’ll probably avoid the mandatory withholding and/or penalties that you would have incurred had you chosen to just cash out your IRA.  If you do decide to cash out your IRA instead of performing a Roth IRA conversion, you’ll also lose out on the benefit of deferring the tax burden and spreading it out over two years.

As you can see, rolling your IRA over to a Roth account or converting your funds to a Roth IRA isn’t without its tax consequences.  However, those tax consequences are less of a burden now than they’ve been in years past, making it a perfect time to consider this change in your retirement savings strategy.  Paying the required taxes now, during your rollover or conversion, may also play an important role in your estate planning, as it will minimize the necessary taxes for those who receive any funds in the Roth IRA from your estate later in life.

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.

So why wouldn’t you convert all of your traditional IRA holdings to Roth IRA accounts right away?  Well, there are a few catches, perhaps the most noticeable of which is that you’ll have to pay ordinary income taxes on any funds you convert to your Roth IRA rollover account.  Let’s look at a few situations in more detail to see where a rollover IRA to Roth IRA conversion makes sense for you:

Do you qualify for a conversion?

Great news – you do qualify, in light of recent IRS changes!  In the past, only account holders with an adjusted gross income (AGI) of less than $110,000 (single or head of household filers) or $160,000 (married couples) were eligible to contribute to Roth IRAs.  Now, however, even taxpayers with higher AGIs can convert funds to Roth accounts, provided they’re already in traditional IRAs.

Do you have the funds available for any applicable conversion taxes?

When you perform a Roth IRA conversion, you’ll be liable for income tax on any earnings or pre-tax contributions in your traditional IRA account, as you’ll have to claim the converted amount on your annual tax returns as income.  If you’ve only got a few thousand dollars socked away, this may be only a minor inconvenience, but if your traditional IRA account balance is much larger, you could be looking at several thousand dollars in tax penalties alone.

On the positive side, the recent IRS changes discussed above also offer some relief to taxpayers facing large tax penalties from Roth IRA conversions.  According to the new Roth IRA conversion 2010 rules, you’ll be able to spread your conversion over two tax years, lessening your tax burden significantly.

Another thing to consider when looking at Roth IRA conversion taxes is whether or not the added income will disqualify you from other federal and state tax benefits.  When you convert funds from your traditional IRA to a Roth IRA, you’ll receive a Form 1099R from your account provider.  Income entered from this statement is counted as general income on your tax return, causing your AGI to go up.  This increase may make you ineligible for other credits – such as child care or education programs – resulting in a net loss to you.

How close are you to retirement?

If you’re nearing retirement age, there are a few things you’ll want to consider before converting.  First of all, your traditional IRA balances are likely much larger than those who are just starting their retirement savings, which will lead to larger tax consequences, as discussed above.  Keep in mind that you’ll have less time to recoup these losses if you’re already close to retirement age.

Additionally, consider whether or not you expect your tax bracket to fall once you enter retirement.  If, for example, decreases in your AGI cause you to move from an effective tax rate of 28% to 15%, it makes no sense to pay taxes on these funds up front instead of later on when you begin taking distributions.