Time to Convert to a Roth IRA?

Has your traditional IRA dropped in value? Do you expect to pay higher federal income tax rates on your withdrawals in future years? If you answered yes to both questions, you have a golden opportunity to convert all or part of your IRA balance into a Roth IRA.

Sure, any amount you convert will trigger a tax hit. But with your traditional IRA balance at low tide (and possibly your overall income, too), the tax hit will be a lot less painful. And after you convert, the new Roth IRA balance can grow federal-income tax free. Eventually you can take tax-free withdrawals after age 59½ when your marginal tax rate may be higher (perhaps much higher) than it is right now. Here’s what you need to know:

A Roth conversion is treated as a taxable distribution from your traditional IRA. That's because you’re deemed to have received a taxable payout from your traditional IRA during the process (even though that money is going straight into the Roth IRA account). So a conversion will generally trigger a federal income tax bill (and maybe a state income tax bill, too). However, there are two factors that make converting now a much more tax-friendly proposition.

* Like most IRA investors, the value of your traditional IRA has most likely been beaten down by stock market losses over the past year. That means you'll pay taxes on a smaller amount, thereby reducing your tax bill.

* Today’s tax rates might be the lowest you’ll see for the rest of your life. Not only will you pay the relatively low current rate when you convert, but you'll also completely avoid higher future federal income tax rates on any post-conversion increase in the value of your Roth account.

While the Roth conversion strategy is a good idea for most folks, not everyone qualifies this year. For 2009, the conversion privilege is only an option if your modified adjusted gross income -- not including any additional taxable income triggered by the conversion itself -- will turn out to be $100,000 or less. (Married individuals who file separately are completely ineligible regardless of their income.) For 2010, the $100,000 restriction is scheduled to disappear unless our beloved Congress changes its mind, which is always a possibility. If the $100,000 rule won’t trip you up this year, then read further for more information.

The extra taxable income triggered by a Roth conversion is added to all your ordinary income from other sources (salary, self-employment income, short-term capital gains, alimony received, and so forth). So if you convert an IRA with a large balance, it could push you into a significantly higher tax bracket (say from 25% to 33% or even 35%). The conversion income also increases your adjusted gross income (AGI), which can potentially trigger a bunch of unfavorable phase-out rules (such as the ones affecting the college tuition deduction, the child tax credit and so forth).

To help you avoid this mess, consider converting a large traditional IRA balance (or balances) to Roth status in stages over at least two years. For instance, you could convert half of your traditional IRA balance this year and the other half next year. This multi-year approach could prevent the extra income triggered by the conversion from pushing you into a higher tax bracket and negating too many AGI-sensitive tax breaks. If this multi-year deal sounds good, I recommend starting this year because the current federal income tax rates are as good as they're going to get. That will probably still be true next year, too. But after 2010, all bets are off.

Another great thing about Roth conversions is you can always change your mind well after the fact. Believe it or not, you have until October 15 in the year following the year your conversion takes place to "recharacterize" (unwind) your converted account or accounts.

Say you convert two traditional IRAs into Roth accounts between now and year-end, and then in 2010, the converted accounts plummet. In this bleak scenario, you'd be stuck paying 2009 income tax on value that later disappeared. Bad idea. Thankfully, however, you have until October 15, 2010 to recharacterize your two converted accounts back to traditional IRA status. If you do so, it’s as if the ill-advised conversions never happened, and you won’t owe any 2009 federal income tax on the now-unwound conversions.

Low current tax cost for converting plus the chance to avoid higher future tax rates on income and gains that will accumulate in your Roth account as the economy recovers (we hope) equal the perfect storm for the Roth conversion strategy. If you’ve got the cash to pay the conversion tax bill, now may be the best time ever to do the deal. That said, consult your tax pro first