Your tax questions answered: IRAs

401k_ira_roth.ju.top.jpg By Amy Feldman, contributor


(MONEY Magazine) -- Late last year you caught a break. Congress reached a deal that extended the Bush-era tax cuts for two years and renewed perks like the sales tax deduction and the tuition write-off for non-itemizers.

Through 2012, the top marginal income tax rate will continue to be 35%, and you'll keep paying just 15% on long-term capital gains and qualified dividends. Plus, in 2011 your paycheck will be a little plumper, thanks to a cut in the payroll tax.

While no one knows what 2012 will bring, this year-end resolution makes planning easier than when rates were in flux. No need to scramble to lock in gains or postpone deductions. But even if Congress eliminated short-term uncertainty, it did nothing to wipe out long-standing confusion about the tax code.

With the filing season underway, MONEY asked readers to share their toughest tax challenges.

From the more than 1,000 questions you submitted, we picked the investing, filing, retirement, home, and small-business topics most likely to lead you off course.

Here are the answers to the most common questions about IRAs.

1. I converted a traditional IRA to a Roth IRA in 2010. Should I claim that income on my 2010 return or defer it? David L., Zeeland, Mich.

You'll need to report that conversion on your 2010 return no matter what. The question is when to pay the tax bill, and the most likely answer is to wait.

With income limits lifted on Roth conversions last year, many high-income investors grabbed the chance to lock in tax-free withdrawals in retirement.

Doing so in 2010 entitled you to a special deal: Pay taxes on the conversion now, or spread the bill equally over 2011 and 2012.

For most, waiting is better. Tax rates are locked in for the next two years, so the only reason to pay the tax right away is if you expect that your income will rise enough in 2011 and 2012 to push you into a higher tax bracket.

2. I am 76 years old. Does it pay to convert my regular IRA to a Roth? -- R.C., New York City

Yes, you're onto something.

Typically you want to convert a traditional IRA to a Roth if you believe your taxes will be higher in retirement or you're decades from needing the cash. But a Roth is also a smart tool for passing on wealth.

You're not required to take distributions (as you are with a traditional IRA). And once you pay the tax on the conversion, you'll never have to pay income taxes again, nor will the children, grandchildren, or any others who inherit.

Says Greg Singer, director of research at Bernstein Global Wealth Management: "There's no better way to pass money on to the next generation."

The biggest stumbling block is today's tax bill -- a conversion is worthwhile only if you can pay those taxes from outside savings.

3. I make about $115,000 a year. I fully fund my 401(k) and would also like to contribute to my Roth IRA. Does funding my 401(k) lower my income enough to let me? -- James G., Washington, D.C.

As you can see from the modified AGI cutoffs, you should have no problem funding a Roth if you put the full $16,500 in your 401(k).

For higher earners, the elimination of income limits on conversions makes it easier to fund a Roth -- in addition to converting existing IRAs, you can open a nondeductible IRA now and convert immediately.

Additional reporting by Anne C. Lee contributed to this article.  To top of page

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