Convert Your Traditional IRA to a Roth?

With stock prices down significantly this year and the prospect for higher future taxes all but certain, now seems to be a compelling time to convert any Traditional IRAs you may have into Roth IRAs. But hurry, you'll need to get on this quickly to make it happen by the end of 2008. Here's a quick review of the highlights:

Converting a Traditional IRA to a Roth IRA is attractive because withdrawals from a Roth are tax-free. With Traditional IRAs, the tax benefit is on the front end, in the form of a tax deduction, but withdrawals are taxed as ordinary income. The difference in tax treatments between these two kinds of accounts means that if you convert from a Traditional IRA to a Roth IRA you'll owe tax this year on the full amount converted. But you'll never pay tax on any withdrawals from that new Roth IRA ever again.

The main question when considering a Roth conversion is whether it's worth it to pay the taxes now to avoid the taxes later. Unfortunately, there isn't a simple "yes" or "no" answer. For most people, conversion boils down to a guessing game about your future tax rate. If you're still working now and think your income and tax rate will be lower in the future, don't convert — wait and pay taxes at lower rates later. However, if you expect your future income to be at least as high as it is today, it may make sense to convert now.

It's generally only worth converting your IRA if you can afford to pay the taxes without taking money out of any other retirement accounts. And it doesn't have to be an all-or-nothing proposition. Partial conversions are allowed.

Also, keep in mind that unlike a Traditional IRA, a Roth does not require mandatory distributions by age 70½ — or at any other age. So, depending on your personal situation, you have more time to grow earnings before taking distributions. Having no mandatory-distribution age also gives you greater flexibility in passing the account to your heirs.

The bottom line is you're trying to solve an equation with lots of variables (such as future tax rates, family situation, market performance, and life expectancy). All you can do is make your best educated guess. That said, if the expectation of higher tax rates down the road does turn into reality, converting now will likely pay off — particularly if we're at or near the lows for this bear market — as you'll have paid taxes at today's lower rates rather than the higher rates of the future.

One last detail: only those with adjusted gross income (AGI) under $100,000 are eligible to convert from a Traditional IRA to a Roth. That is scheduled to change in 2010. Unless the law is further changed, it will also allow the tax impact of conversions to be spread over two years rather than just one.