One of the hottest topics in the tax world today deals with conversions.  I’m not talking about changing religions, although some will argue that given the economic conditions today, more people are praying than ever before.  I’m referring to a change to the tax law involving converting from a traditional IRA to a Roth IRA.

Before I discuss the conversion, you need to understand the similarities and differences between traditional and Roth IRAs.  Both are retirement investments and both grow tax-deferred while in the account.  That’s where the similarities end.  While you may qualify for an immediate tax deduction if you fund a traditional IRA, no such deduction is allowed for funding a Roth IRA.  On the flip side, when you withdraw monies from a traditional IRA, you are taxed on the entire proceeds, while the withdrawals from a Roth IRA are completely tax exempt.  Please keep in mind that I am only referring to withdrawals after a normal retirement date and not premature or early withdrawals.  Also remember that to avoid a penalty on withdrawal, the ROTH plan must be in effect for five tax years and you must attain the age of 59 ½.

In 2010 everyone is allowed to convert their traditional IRAs to Roth IRAs.  This is completely new and was not an opportunity that everyone had in the past.

Under the 1997 tax law governing Roth IRA conversions, individuals were permitted to convert traditional IRAs to Roth IRAs.  Of course, the government didn’t make it that simple.  There were two major stipulations.  There was an income limit which determined eligibility and, of course, anyone converting had to pay taxes on the converted funds.

Traditional IRAs could contain funds deposited on either a pre-tax and after-tax basis.  That investment is allowed to grow on a tax-deferred basis until withdrawn.

If an individual wanted to convert a traditional IRA to a Roth IRA they had to pay federal income taxes on any pre-tax contributions as well as any growth in the investment's value.  After all, once converted to a Roth, all of the investment could now be withdrawn after normal retirement, tax-free.

Unfortunately, that same 1997 tax law also contained a provision limiting who could make a conversion.  Taxpayers with adjusted gross income in excess of $100,000 - whether single or married - were not eligible to make such a conversion.

Also, if your income exceeded $110,000 for single taxpayers or $160,000 for married joint filers, you were ineligible to contribute to a Roth IRA. These two tax laws effectively precluded upper income taxpayers from enjoying the benefits of a Roth IRA.  Not only couldn’t they convert their traditional IRAs to Roth IRAs, but they couldn’t fund one either.

Back in May 2006, President Bush signed a $70 billion tax cut provision changing the eligibility rules for Roth IRA conversions.  Starting in 2010, all taxpayers, regardless of income will be allowed to convert from a traditional IRA to a Roth IRA.  Currently, this change applies to all years beginning with 2010 - and the income taxes due on the 2010 conversion can be spread over two years.  That means that the amount converted to a Roth in 2010 may be included as taxable income in 2011 and 2012 rather than being included in 2010’s taxable income.  Conversions in all subsequent years would be includable in income during the tax year in which the conversion is completed.

Removing the Roth IRA conversion cap however doesn't mean anyone can fund a Roth IRA, but it does mean that anyone can convert an existing IRA to a Roth IRA plus any gain in the account.

There is one important rule to keep in mind when it comes to converting a traditional IRA to a Roth IRA - you need to pay federal income taxes on whatever portion of the conversion that previously was treated as a deductible IRA.

Here are 3 examples of what to expect.  For all 3 examples, we will assume that there is a $20,000 balance in the IRA.

Example 1

Let's assume that you funded a traditional IRA with before-tax dollars - meaning you took a deduction on your tax return for the money placed in the traditional IRA.

In this example, you haven't paid income taxes on any of the money in the account, so when you convert it to a Roth IRA, taxes are owed on the entire account balance.  In this case you'd have to pay income taxes on all $20,000 in your fund. 

Example 2

Assume that you started funding a traditional IRA in 2006 and by 2010 you've got $20,000 in your account and that it consisted of four years of $4,000 non-deductible contributions for a total of $16,000 in non-deductible contributions and $4,000 in account growth.

In this example, you would be taxed on the $4,000 in fund growth, but not the $16,000 when you convert to a Roth IRA.

 Example 3

Assume that you have both an existing traditional IRA with contributions that were previously deducted and a second IRA that was funded with non-deductible contributions.  In this case, any conversion is done on a pro-rata basis.  So, if you have $12,000 in a regular IRA and you had $8,000 in a non-deductible IRA and wanted to convert $5,000 to a Roth, then you'd owe taxes on $2,400 because the pro-rata share of your pre-tax contributions and income is 60% of the total.

The only truly good news is that once you convert the assets from a traditional to a Roth and pay the tax, you never will pay tax on the monies again nor would your heirs if they inherit any or all of it.  Also, it is important to note that the tax must be paid from non-IRA funds.  Otherwise, it would be a taxable event and may be subject to an early withdrawal penalty depending on the participant’s age.

One potential benefit lies with those of advanced age with significant assets including traditional IRA assets.  By converting and paying the taxes immediately, not only do the assets pass income tax free to the beneficiaries, but the taxes paid will reduce the person’s overall estate, thereby potentially saving Estate Tax as well.

Let’s assume a person will have a taxable estate of $10 million of which $2 million is in a traditional IRA.  Further, let’s assume that both the owner of the assets and the potential heirs are in the same income tax bracket of 35%.  The tax on the conversion would be $700,000.  That $700,000 is paid from the existing assets thereby reducing the estate and, assuming an estate tax rate of 48% would result in a savings of $336,000 of federal estate taxes.

While it might be very exciting for some individuals to learn that they can use this 2010 law to convert an IRA to a Roth IRA, it's important to mention that Roth IRAs are not for everyone.  Before converting you need to fully understand the consequences and recognize that making the wrong decision could prove costly.  There are numerous calculators available only to run through all of the what-if scenarios.

It's always best to make an informed decision.  It is particularly important to consult with a tax professional before deciding if taking advantage of the rule change in 2010 is right for you.

Here are a few of the factors that go into the decision making process when considering converting to a Roth.

1.            What is your current tax rate

2.            How old are you

3.            What is the anticipated return on your investments, both in and out of the IRAs

4.            When are you likely to retire

5.            Do you anticipate making withdrawals before age 70 ½ when the required minimum distribution rules go into effect

6.            Will your income level at retirement be similar to your income level today

7.            Will income tax rates increase, remain the same or decrease

8.            If you die, what is the anticipated income tax rate for your beneficiaries

9.            What happens if you take the income taxes needed to pay for the tax on the conversion from the existing traditional IRA

10.    Who is best suited to do the calculations

11.    Does this change in the law go under the heading of “I’m from the government and I’m here to help”