How to sail into retirement tax-free

A tempting tax window opens in 2010 for many folks with individual retirement accounts. In 2010 anyone, regardless of income, can convert any tax-deferred IRA into an after-tax Roth IRA. In prior years, you had to have a modified adjusted gross income of $100,000 or less to convert a traditional IRA to the Roth kind.

Roth IRAs are attractive for a number of reasons. They're funded with after-tax money, so you'll owe no tax on distributions as long as you're at least 59½ and the account is at least five years old (though a few exceptions apply). If your investment and tax rates rise in the future—a reasonable but not watertight assumption today—you could save by paying tax now on a distribution from a regular IRA and converting it to a Roth. And unlike with a traditional IRA, you don't have to take required minimum distributions from a Roth after you reach age 70½.

IRS giveth, IRS taketh away

The downside is that money you move to a Roth from a traditional IRA counts as added income for 2010 and is taxed at ordinary income-tax rates. The added income could put you in a higher tax bracket. But the IRS will let you pay the entire tax for tax year 2010 or split it 50-50 between 2011 and 2012 (see Keep these dates in mind for Roth conversion). That second, seemingly attractive option could turn ugly if federal tax rates rise for those years.

A Roth conversion makes sense for those who want to leave income-tax-free inheritances. As with any IRA, money left in a Roth at your death goes to your designated beneficiaries. Surviving spouses who roll over the Roth to make it their own don't have to take required minimum distributions. Other individuals who are beneficiaries must take distributions, but they won't pay income tax or penalties as long as the Roth is five years old.

The Roth conversion is considered a boon for the wealthy as an estate-planning tool. But even people with modest means might want to convert all or a portion of their IRAs to a Roth so they won't have to take a required distribution in the future. And unlike withdrawals from traditional IRAs, Roth distributions aren't counted as income in determining the taxable portion of your Social Security benefit, if any.

CPAs and financial planners say anyone considering a Roth conversion should be able to say "yes" to the following:

You expect to be in a higher tax bracket in retirement

Remember to consider where you expect to live then. Higher federal income taxes might be offset by lower or no state taxes, making the conversion less beneficial.

You have a long time horizon

If your money grows more as a result, you'll compound your tax savings.

You can pay the tax on the IRA distribution from other accounts

The tax money should be drawn from assets that create the lowest possible taxable capital gains, says Taylor Gang, a certified financial planner and vice president at Evensky and Katz, a wealth-management firm in Coral Gables, Fla. If you use money from the IRA or another retirement account, you're defeating their original purpose.

Allowing for a change of heart

The good news is that you can change your mind. You can convert in January 2010 and wait until Oct. 15, 2011—the extension date for your 2010 taxes—to "recharacterize" the Roth IRA back to a traditional IRA. That would be useful if your investments drop. You can recoup the taxes you paid on $100,000 converted in January 2010 that's worth, say, $80,000 in October 2011.

Opting for the mid-October 2011 extension date to file your 2010 return also lets you see what Congress plans for tax rates. If they're going up, you can elect to use tax year 2010 and avoid higher taxes later. If they're not changing, you can opt to split the tax between tax years 2011 and 2012.

"The nice thing about a Roth conversion is that it allows you to do tax planning with 20-20 hindsight," says Teal Dakan, a CPA and partner in the Kansas City, Mo., office of BKD, an accounting firm.