A traditional individual retirement account (IRA) may be converted to a Roth IRA, fully or partially. Such a conversion involves a tradeoff, as follows:

• On the negative side, a conversion now requires earlier payment of deferred income tax. Without a conversion, tax may be deferred income tax.
• The positive aspect of a conversion is the prospect of future tax-free income. Five years after opening a Roth IRA, all withdrawals will be tax-free, as long as you’re at least 59 1⁄2 years old.

In addition, no minimum distributions from a Roth IRA are required. If you don’t need the money, you can leave it in the account indefinitely, benefiting from tax-free buildup. Moreover, your beneficiaries can stretch out tax-free withdrawals over their lifetime.

The $100,000 question

For many taxpayers, Roth IRA conversions are appealing. Generally, the longer you have until you plan to take withdrawals, the more a conversion makes sense.

There is a catch, though. You can’t convert a traditional IRA to a Roth IRA in a year when your income is over $100,000. This upper limit applies to single and joint tax returns. The $100,000 income ceiling has prevented some people from implementing a desired conversion.

The new tax law eases those rules. Beginning in 2010, anyone with a traditional IRA can convert it to a Roth IRA, and it won’t make any difference how much income you report.

A special rule applies to conversions in 2010. Unless you elect to recognize the taxable income resulting from the conversion in 2010, that income will be averaged between your tax returns for 2011 and 2012.

Planning possibilities

Even though the $100,000 limit on income applies through 2009, you can begin to do some planning now. As long as you have earned income this year, you can make a non deductible contribution of up to $4,000 to a traditional IRA in 2006. If you’ll be at least 50 years old by December 31, you can contribute up to $5,000.

For married couples, each spouse can make a $4,000 or $5,000 nondeductible contribution in 2006, as long as one or both spouses work.

(The same $4,000 and $5,000 opportunities apply to deductible contributions to traditional IRAs and nondeductible contributions to Roth IRAs, but income and other limits apply. Nondeductible contributions to traditional IRAs can be made regardless of income.)

Similar nondeductible contributions to traditional IRAs can be made for each subsequent year. The $4,000 and $5,000 limits will be increased each year to keep up with inflation. Through 2010, therefore, a married couple in their 50s with at least one working spouse could contribute more than $50,000 to their traditional IRAs, no matter what their income. Then, in 2010, high-income taxpayers could convert their traditional IRAs to Roth IRAs, including amounts derived from nondeductible contributions.

Roth IRA Income Limitations

Fine Points

If this strategy sounds attractive, some issues should be considered.

Mixing deductible and non deductible contributions. If you already have a traditional IRA that was generated by deductible contributions, adding nondeductible contributions increases the paperwork and the complexity of figuring out the tax on distributions.

To minimize such complexity, plan on converting all of your traditional IRA to a Roth IRA in the same year. (You’ll still need to work with your CPA to determine the right amount of income to recognize and avoid paying tax on already-taxed nondeductible contributions.)

Cash concerns. For the best results, you should pay tax on any Roth IRA conversion from other funds rather than from the money in your traditional IRA. The larger the amount you can keep in the Roth IRA for long-term accumulation, the greater the ultimate tax-free payoff, so start putting some money aside.

Congressional second thoughts. Depending on politics and federal budgeting, Congress could once again change the law before higher-income Roth conversions become available in 2010.