For the first time ever, high-income taxpayers are eligible to convert a traditional IRA to a Roth IRA. Prior to 2010, you could not convert to a Roth in a year in which your modified adjusted gross income exceeded $100,000. But this limit was removed by a 2006 tax law change that took effect January 1, 2010. So the question of the year is, should you do a conversion? There are numerous factors to take into account.

First, you must understand the critical differences between the two IRAs. With a traditional IRA, contributions may be partially or wholly tax-deductible, but distributions are generally taxable at ordinary income rates. In contrast, contributions to a Roth IRA are never tax-deductible, but qualified distributions from a Roth in existence at least five years are completely exempt from tax. Qualified distributions are those made after age 59½, due to death or disability, or used for first-time homebuyer expenses (lifetime limit of $10,000). Also, unlike a traditional IRA, mandatory distributions after age 70½ aren’t required for a Roth.

Thus, by converting to a Roth, you pay an up-front tax on the current value of IRA assets in exchange for future tax-free withdrawals. For a conversion occurring in 2010, you can choose to split the taxable income evenly over the following two years, 2011 and 2012.

In analyzing whether you should convert or not, consider the following points:

1. If you have to pay all or part of the conversion tax with funds in your traditional IRA, the benefit of the conversion is diluted. The account can grow even larger if you have other resources to pay the required tax.
2. Consider state income tax implications. In some situations, the combination of federal and state income tax liability could discourage a conversion.
3. Both your current income tax rate and your projected income tax rate can affect your decision. For instance, if you’re now in a high tax bracket but expect to be in a much lower bracket in retirement, you may be less inclined to convert from a traditional IRA. Conversely, the prospect of rising tax rates generally favor a Roth conversion.
4. Spreading out the tax liability for a 2010 conversion over the next two years may not be the right choice in your situation.
5. Converting to a Roth could trigger alternative minimum tax (AMT) liability.
6. Be aware that you don’t have to convert the entire balance in an IRA or all your IRAs. Partial conversions are permitted. Finally, you have the ability to “recharacterize” a Roth back into a traditional IRA if it suits your needs.

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