If you're willing to trade paying taxes today for future tax-free promises, here are the issues you'll have to consider. (By the way, the most detailed presentation of these tradeoffs can be found online at Schwab.com.)
When to pay the taxes: If you do the conversion from a traditional IRA to a Roth IRA in 2010, you have a choice of recognizing all that income in the same year (2010) -- or split equally between the next two tax years (2011 and 2012). Either way, it's going to be a huge tax bite.
Remember, your traditional IRA or IRA rollover accounts are filled with pre-tax contributions along with untaxed gains over the years. When you do the conversion, you'll add all that previously untaxed "income" to your current income to determine your tax liability.
Where to get the tax money: Don't plan to use money from the IRA to pay the taxes. If you do, you'll lose the main reason for doing the conversion: future tax-free growth of all that IRA money. And if you're under age 59-and-a-half and take IRA money to pay the taxes, you'll face that 10 percent penalty.
That means the conversion is most advantageous if you pay the tax bill with savings you've built up outside your IRA account. But how will you feel about writing that huge check to the government next year? What better things might you have done with that money you're sending to the government to pay the conversion tax?
As you sit down to consider the numbers, these nagging worries may make you think twice about doing that Roth conversion. Future tax-free withdrawals (made at least five years after conversion) are tempting. But writing a huge check to the government next year might be even more painful than those long-term promised benefits.
The one group that might benefit most from this conversion opportunity are younger savers. They'll have more time for the money to compound, and overcome the taxes paid now. Then all that money would come out tax-free at retirement.
And for those who have lots of money, there is an additional benefit to converting to a Roth. Not only are there no required minimum withdrawals from a Roth (at age 70-and-a-half), but if you don't spend the money in your lifetime, your heirs can allow it to continue to grow tax free, or withdraw it tax free -- unlike withdrawals by beneficiaries of a traditional IRA.
Plus, by paying taxes on the money now, at today's relatively low rates, you lower the amount of your estate. That might be helpful if the estate tax returns at much higher rates.
Yes, this is a complicated decision. That's why it's important to discuss this with your tax adviser well in advance. And if you can't come down on one side or the other, you can always convert a portion of your IRA. That way you'll never have complete regrets about your decision. And that's the Savage Truth.