If you currently have an IRA, SEP-IRA, SIMPLE IRA, or participate in a 401(k)/403(b)/457 plan and are eligible to take a distribution, please take the time to read this. For the purpose of simplicity, we will use the term “IRA” to refer to all of these account types.

Much has been written in recent weeks about the change in the law affecting IRA conversions to Roth IRAs, effective January 1, 2010. And, no doubt, much will be written in the coming year.

Assets in an IRA account grow tax-deferred, but withdrawals are taxed at ordinary income tax rates at the time of withdrawal. Assets in a Roth IRA account also grow tax-deferred, but withdrawals are tax-free (as long as you are at least age 59½ and have had the account for at least 5 years). Under current law, an individual is able to convert IRA assets to a Roth IRA to take advantage of the tax-free withdrawals, but only if his modified adjusted gross income does not exceed $100,000. The individual would pay income tax on the amount converted, due in the year of the conversion.

Effective on January 1, 2010, the income restriction will be removed, allowing anyone to convert an IRA to a Roth IRA (the existing income restrictions will remain on Roth IRA contributions). Filers converting in 2010 get an added benefit – extra time to pay tax on the conversion. Instead of reporting the income on their 2010 tax returns, taxpayers have the option (but not the requirement) to report half of the income on their 2011 returns and the other half on their 2012 returns. Essentially, this means that you are able to convert your IRA on January 4, 2010 (the first business day of the year) but delay payment of the taxes until April 2012 and April 2013!

• Account balances are still down from their peaks in October 2007. Converting in 2010 will mean that any further recovery will be completely tax-free to you.
• Tax rates are at historic lows. The top federal rate is 35%, compared with rates as high as 94% in the distant past. The top rate was 91% in 1964, 70% in 1981 and 50% in 1986. The Bush tax cuts are also set to expire in 2011, which will raise the tax rates. Converting IRA assets in 2010 could allow you to do so at a preferable tax rate.
• Roth IRA owners are not subject to required minimum distributions, while IRA owners must begin taking distributions when they reach age 70½. Converting would give you more control over when and how you take withdrawals.
• Younger people will have a long lifetime of tax-free growth. However, older investors have reason to consider the Roth as well. Currently, if you name your spouse as the beneficiary of your Roth IRA, your spouse can treat the inherited Roth IRA as his or her own after you die and forego withdrawals - so those Roth IRA assets can keep compounding untaxed across the rest of your spouse’s life. If your spouse then names a child or grandchild as a beneficiary, that heir has the choice to make minimum withdrawals according to his or her life expectancy, all while the assets continue to compound tax-free. Currently, withdrawals from an inherited Roth IRA are not subject to income tax.
• If you change your mind about a conversion, you may undo it through a “recharacterization” as long as you do so by October 15th of the year following the year of the conversion. Therefore, if the value of the IRA falls sharply after you convert it, or if you simply change your mind, you may reverse the conversion.

• If you will need to access the converted assets within the next 5 years, converting the entire account may not be wise (but a partial conversion may still make sense). That’s because withdrawals from a Roth IRA within 5 years of conversion may be subject to a 10% penalty.
• If you are concerned that doing the conversion will increase your adjusted gross income, thereby making you ineligible for certain tax deductions, and/or cause more of your Social Security benefits to be taxable, you may not be inclined to convert (although you must weigh the disadvantage of lower deductions in one year against the long-term tax savings of the Roth IRA).
• The IRS regards a traditional IRA-to-Roth IRA conversion as a distribution from a traditional IRA – a taxable event. You’ll need to pay taxes on the entire amount of the conversion (after adjusting for any after-tax money in the account). If you don’t have the available cash to pay this tax outside of your IRA accounts (again, due with your 2011 and 2012 tax returns), converting may not be wise.
• If you are in a high tax bracket and expect to be in a much lower tax bracket in the future, then converting may not make sense.

For many people, converting an IRA to a Roth IRA will make sense or, at the very least, warrant careful consideration. The decision will be based on an individual’s age, tax bracket, personal outlook regarding the likelihood that our government will increase tax rates, how important it is to have control over annual withdrawals, and how important it is to pay the tax for future generations. There is no simple answer and it will require looking at each unique situation.

One of the most frequently asked questions is whether we can trust the federal government to keep its word about tax-free withdrawals from Roth IRAs. There are no guarantees as to what might happen in the future if budget deficits keep expanding. However, eliminating the tax-free provision would be a politically risky move since most of those in office voted for this provision. And, even if the government somehow changes the rules to make Roth IRAs less appealing, it is reasonable to assume that existing accounts could be grandfathered, based on past actions by Congress.

Some of you may not have an IRA or eligible retirement account. If that is the case and if you are prohibited from contributing to a Roth IRA due to high adjusted gross income, you might consider making a non-deductible (after-tax) contribution to a traditional IRA. Then, beginning in 2010 you would be eligible to convert these assets to a Roth IRA…essentially a “back-door” into the Roth IRA.