On Dec. 28, 1999 I converted 25% of my regular IRA to a Roth IRA. I would like to convert a similar amount in 2000, and again in 2001 and 2002. With all the talk of the supposed fall rally, I would like to make this year's conversion ASAP.

I called the Internal Revenue Service help line about this. I was told I could not make this year's conversion until Dec. 29 because I had to wait a full year between conversions. This does not sound right to me, but I'm only a lowly taxpayer. Can you please clarify my options?

-- Ken Lynch

Ken,

I think the folks working the IRS hotline might be confusing things.

In a nutshell, you can convert a portion of your IRA to the Roth as often as you like. But starting this year, you only can move that Roth money back to your IRA once a year. It think that's where the confusion may lie.

Since you are moving money in only one direction -- from your IRA to your Roth -- this once-a-year limitation doesn't apply to you. But you should be aware of the details in case you change your mind at some point and decide to move some converted Roth funds back to your IRA.

Why would you do this?

Let's say you converted 25% of your traditional IRA to the Roth in June 2000. You'll owe ordinary income tax on the amount of that conversion when you file your 2000 tax return next April.

But you were heavily invested in Amazon.com (AMZN:Nasdaq - news), which has fallen 33% since June 1, and your account has taken a big hit.

Even so, you still owe tax on the value of the account on the day you converted -- not its diminished current value. To avoid this extra-large tax smack, you can move that Roth money back to your traditional IRA (it's called "recharacterizing" in tax parlance).

Now you've avoided the big tax hit, but you're back where you started. And you still want to move 25% of your IRA into a Roth.

You can't.

The IRS allows only one such "flip-flop" per calendar year because it wants to discourage market-timing by IRA investors. So you'll have to wait until after the following Jan. 1 to move that money from your IRA to the Roth, otherwise it will be considered a taxable early distribution from your IRA.

But there's one more thing to keep in mind. The official rule says if you've flip-flopped once in a calendar year, you may not convert IRA money back to a Roth before either the beginning of the next tax year or 30 days after the amount was recharacterized, whichever is later.

Let's clarify that with an example.

Let's say you converted to the Roth on June 1, and recharacterized back to a traditional IRA on Aug. 1.

Before you can convert back to the Roth again, you have to check two dates: Jan 1, 2001 (beginning of the next tax year) or Aug. 31, 2000 (30 days after you recharacterized). Because you now must wait until the later of the two dates, you can't convert back to the Roth until Jan 1, 2001.

Check out our Roth IRA reporting guide for details of how to report your recharacterization on Form 8606 -- Nondeductible IRAs.

Now, back to your situation, Ken.

Assuming your 1999 adjusted gross income (line 34 of Form 1040 - U.S. Individual Income Tax Return) did not exceed $100,000 in 1999, your 25% conversion was legit. If you filed your 1999 tax return back in April, you should have already paid the tax due on that 25% conversion.

Going forward, as long as your adjusted gross income does not exceed $100,000, you can continue to convert as much as you want, as often as you want, to a Roth IRA, says Maggie Doedtman, a senior tax-research and training specialist at H&R Block in Kansas City.

Just be aware that you'll owe ordinary income tax on every dollar you convert to the Roth when you file your tax return. You do not owe the money at the time of conversion. You will get a Form 1099R some time around March 2001 that will detail the amount of your conversion that's taxable for 2000.

What Do I Owe Taxes On?

When converting from a traditional IRA to Roth IRA, do you have to pay taxes on the whole amount or just the gains? I liquidated a 401(k) years ago and rolled it into an IRA. The amount rolled was around $20,000, and I have made $5,000 after buying and selling a stock. Do I only pay taxes on gains from the 401(k) (and how would I find out those past details?) and from current IRA, or on the whole $25,000?

-- Rich Dixon

Rich,

You will owe tax on all of it.

I'm assuming you only contributed pretax money to your 401(k). If that's the case, you never paid tax on any of those contributions. If your contributions generated earnings, great. But you never paid tax on that money either.

Rolling the money from a 401(k) to an IRA is a tax-free transaction. So you still aren't paying Uncle Sam a dime.

But remember, you only can contribute after-tax dollars to a Roth. Since you haven't paid any taxes on the money in your IRA, you'll owe ordinary income tax on the whole amount.

If you made after-tax contributions to your 401(k), they would be distributed to you before the remainder of the account was rolled into the IRA. (Check out this previous Tax Forum for more details on after-tax 401(k) contributions.) If you made nondeductible contributions to your IRA, you would not owe ordinary income tax on those contributions when you roll the account to the Roth. But you would owe tax on any earnings those contributions generated.