Pros, cons of converting your IRA to a Roth account

Last week's article focusing on Roth IRA conversions for low- and middle-income folks sparked an unusual number of reader responses (which was fun). The flurry reflects the growing excitement over conversion in 2010. But the e-mails also emphasized the complexity of the issue. So I've decided to recap the basics of conversion with some help from readers.

Up until now you could only convert a traditional IRA into a Roth IRA if your modified gross adjusted income was under $100,000. The income limit lifts in 2010.

Tom at the University of Minnesota wanted me to emphasize that when you convert from a traditional IRA to a Roth you owe income taxes on the amount converted. He's right. The reason is a traditional IRA is funded with pretax dollars. You'll pay ordinary income tax rates on the money when it's taken out in retirement. A Roth is funded with after-tax dollars and any earnings are withdrawn tax-free during retirement.

Should you convert? The argument for converting strengthens the longer your money can compound before retirement. However, it's critical that you have other savings on hand to pay Uncle Sam's upfront tax bill -- you don't want to tap into your IRA money to pay the tax levy. You also have to calculate that paying taxes upfront is the best use of your savings compared with, say, maintaining a flush emergency savings account.

There are other advantages of a Roth. I think the most important one is that there is no required minimum distribution with the Roth as there is with a regular IRA. That's why, for those with substantial assets, converting to a Roth may make financial sense from an estate planning point of view.

Jay in Eagan noted that with the 2010 conversion you have the option of spreading the tax bite in half and paying it out over two years. It's a one-time tax perk. Of course, the option adds a layer of complexity. For instance, whether you should pay the tax tab in full in one year or split it in half over two years depends on whether you believe the money you make off the delayed payment will offset the risk of a higher tax bill.

Dave in St. Paul wondered if money in a company's 401(k) plan can be converted to a Roth. In general, the rule is that if you have an active retirement savings account at work you can't convert it into a Roth. (You can do it if you're no longer on the job, of course.) However, if you're over 59 1/2 and still working at your company you can withdraw without penalty the money in your employer's defined contribution pension plan and place it in a Roth. Your company's pension plan document must allow for such an "in-service" distribution. Like a conversion from an IRA, you need to pay ordinary income taxes on the withdrawn money.