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.

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.

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.