Whether you use a rollover or a transfer, converting money to a Roth individual retirement arrangement will likely cost you on your current tax return but save you money in the long run. Once you’ve converted, your qualified distributions come out tax-free. In addition, it won’t affect your ability to contribute for the year. As of 2012, the maximum annual contribution for a Roth IRA is $5,000 ($6,000 for those 50 or older).
Contribution Limit Unaffected
A conversion to a Roth IRA does not count toward your annual IRA contribution limit. As a result, no matter how much you convert during the year, you can still make a contribution to either a traditional IRA or the Roth IRA that you rolled money into as if the conversion didn’t happen. For example, if you roll over $3,000, you don’t have to lower your annual contribution limit by $3,000. However, any amount you contribute to a traditional IRA and then roll over later that same year still counts toward your annual contribution limit.
Roth IRA Contribution Eligibility
Even though the Roth IRA conversion doesn’t count as your annual contribution, you can’t contribute to the account if you aren’t eligible. To be eligible, you must have compensation income and your modified adjusted gross income can’t exceed the annual limits. The income limits vary depending on your filing status and the year because the Internal Revenue Service updates them for inflation. You can find the current in IRS Publication 590. However, the limits are cumulative with traditional IRA contributions, so each dollar you’ve added to a traditional IRA during the year reduces your Roth IRA contribution limit.
Conversion Doesn't Affect MAGI
Roth IRAs limit your ability to contribute if your modified adjusted gross income is too high. However, even though your Roth IRA conversion counts as taxable income, it isn’t included in your modified adjusted gross income. The IRS makes a special tweak in the modified adjusted gross income formula that takes out any income from a Roth IRA conversion. For example, say your adjusted gross income is $115,000, including a $10,000 Roth IRA conversion. When you go to figure your modified adjusted gross income, you take out that $10,000 so your modified adjusted gross income is only $105,000.
Traditional IRA Contributions
Even if you convert your entire traditional IRA to a Roth IRA, you can still make a traditional IRA contribution for the year as long as you’re eligible (assuming you haven’t already). Besides having compensation during the year, the only restriction on making traditional IRA contributions is that you must be younger than 70 1/2 at year’s end.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."