Traditionally, high income individuals have been barred from converting a traditional IRA into a Roth IRA in a year when their modified adjusted gross income (MAGI) exceeded $100,000. Starting in 2010, you can convert a traditional IRA into a Roth IRA no matter how high your income is (unless Congress changes the law).

Traditional vs Roth
There are several similarities between a regular IRA and the Roth version. For instance, the contribution limit for the 2009 tax year is $5,000 for either type of IRA or a combination of the two. (The limit is $6,000 if the account owner is age 50 or older.) With each IRA, no current tax is due as earnings accumulate over time.

But the differences are far greater. For starters, regular IRA contributions may be tax-deductible, in whole or in part, based on income and active participation in other retirement plans. In contrast, Roth IRA contributions are never deductible. Also, traditional IRA holders must take mandatory distributions from their accounts the year after the year they reach age 70½. (This rule is temporarily suspended for the 2009 tax year.) Lifetime distributions are not required with Roth IRAs.

Perhaps the biggest difference is that distributions from regular IRAs are taxed at ordinary income rates. Only the amounts attributable to nondeductible contributions are tax-free. Conversely, qualified distributions from a Roth in existence for at least five years (e.g., distributions made after age 59½) are completely exempt from tax.

If a regular IRA is converted to a Roth, the transfer is a treated as a taxable event, such as a distribution. But this can lead to tax-free distributions in retirement.

Conversion Bonus in 2010
Under the massive 2006 pension law, the $100,000-of-AGI barrier is being removed for the 2010 tax year. Thus, many high-income earners will qualify for a conversion for the first time. To sweeten this tax break, an account holder who converts in 2010 can elect to pay the resulting tax liability over the following two years. This not only defers payment but it also reduces the overall tax bill.

This multi-year approach can prevent the extra conversion income from pushing you into higher tax brackets and negating AGI-sensitive tax breaks. If a multi-year strategy sounds good, start this year (if possible) because the 2009 federal income tax rates are probably as good as they are going to get. That will probably still be true next year. But after 2010, all bets are off. Rates for higher-income individuals may go up, which could make the multi-year conversion strategy inadvisable. (Hopefully, you'll know your 2011 tax situation by the end of next year and will have time to plan your Roth conversion moves accordingly.)

To Convert or Not to Convert
These changes represent a prime tax-planning opportunity, especially if IRA assets remain undervalued compared to several years ago. Furthermore, you can elect to recharacterize a Roth IRA into a regular IRA in the event that future conditions dictate so. The recharacterization must take place prior to the tax return deadline (plus extensions) for the year of the conversion.

At first glance, a Roth IRA may not seem worthwhile. You cannot deduct Roth IRA contributions in the current year, while you can make tax-deductible contributions to a traditional IRA if you meet the income requirements. The advantages of a Roth IRA come later. When you take withdrawals from a Roth IRA, you don't have to pay taxes, as long as the account has been open for more than five years and you're at least 59.5 years old. In contrast, withdrawals from a traditional IRA are taxable.

Careful consideration should be given before you proceed with a conversion. Talk to your trusted advisor to determine if a conversion is right for you. Generally, it makes sense to take advantage of the conversion opportunity if you:

• Can cover the conversion taxes outright (in cash or by tapping other non-retirement savings)
• Will wait at least ten (10) years before you take any distributions
• Expect that you'll be in a higher tax bracket in the long-term future
• Plan to leave significant retirement assets to your heirs
• Expect a lower income in 2010
• Want more flexibility regarding retirement withdrawals
• Expect poorly performing non-Roth retirement accounts to improve

Prepare for 2010 Now
Planning for 2010 is part of the year-end process. Converting to a Roth IRA will trigger a current income tax bill because you're deemed to receive the converted amount in a taxable distribution from the traditional IRA. But if your traditional IRA balance is low (and possibly your overall income too), the conversion tax hit will be less.  The relatively low current tax cost for converting, combined with the chance to avoid higher future taxes on additional wealth that accumulates in your Roth account as the economy recovers, add up to the perfect storm for a conversion. However, you must plan ahead. Consider the following before making any final decisions:

• Determine if your increased adjusted gross income resulting from a conversion would make you ineligible for other, highly beneficial tax breaks before converting
• Take steps to shift taxable income from 2009 into 2010 to reduce this year's MAGI if you want to begin taking advantage of the multi-year conversion bonus this year as well as next year
• Begin saving money to pay the conversion tax bill, even if you plan to spread the taxable income over two years to defer the related federal taxes
• Consider splitting up a large traditional IRA into several smaller IRAs prior to converting them into Roth IRAs so that you can implement different investment methods for each Roth account
• Reverse the conversion for any under-performing Roth IRAs that were converted this year

Please contact us for additional guidance on year-end planning strategies and IRA conversions. Call us today. We can help.

Michael I. Daszkal, CPA co-founded the firm in 1992. He continues to lead the firm as Chairman of the Executive Committee and Partner in charge of the Audit and Accounting Services Department.  With 20 years in the accounting industry, Michael's expertise transcends many areas of auditing and accounting, including due diligence, mergers and acquisitions, preparation of financial statements and SEC rules and guidelines. His practice focuses on providing professional services to businesses and individuals in the areas of auditing, accounting, business consulting and tax matters.