Once you move your retirement savings to a traditional IRA, you have another option: You can convert some or all of it to a Roth IRA.
Although you will pay taxes on money you convert, all future withdrawals will be tax-free as long as the account is open at least five years and you are at least 59½ years old at the time.
The longer the money sits in a Roth IRA allowing tax-free earnings to accumulate, the bigger the tax savings. As noted above, there are no mandatory distribution rules for Roth IRAs and if you decide to leave your Roth IRA to your heirs, they will inherit it tax-free as well.
Since your tax rate is based on your income, you may want to wait until you retire when your taxable income may be lower to convert a portion of your IRA to a Roth IRA each year, to prevent you from being bumped into a higher tax bracket.
Starting in 2010, there are no income limits on who can convert a traditional IRA to a Roth IRA.
You can now convert directly from a 401(k) to a Roth IRA, without the trouble of rolling over to a traditional IRA first. And if you have any after-tax contributions in your 401(k) or similar employer-based retirement plans, such as a 403(b) or 457 plan, you can roll over those funds directly to a Roth IRA tax-free.
This new 401(k) conversion rule is much more liberal than the one that controls conversions from traditional IRAs to Roth IRAs. In that case, the tax-free portion of the rollover is based on the ratio of your non-deductible pay-ins to the total amount in all of your IRAs. So if your $60,000 IRA contains $6,000 in non-deductible contributions and you convert $6,000 to a Roth IRA, just $600 or one-tenth of the converted amount would escape income tax. The remaining $5,400 would be taxed at your regular income tax rate.
But in the same situation with the new 401(k) rules, the full $6,000 converted from your 401(k) to a Roth IRA would avoid tax. Depending on your plan’s rules, you may not be able to roll over the after-tax contributions until you leave your job.