Convert Now to a Roth IRA?

Should I convert my traditional IRA to a Roth before the end of the year?

If your account took a beating over the past few months (as most have), then this might be a great time to convert your traditional IRA to a Roth. You have to pay taxes on the entire amount you convert (except for any nondeductible contributions) no matter when you make the switch, so the lower your account value, the smaller your tax bill.

But there's a big benefit to waiting: If you convert to a Roth in 2009 instead of 2008, you may not have to pay taxes on the conversion until you file your return by April 15, 2010. You could be better off waiting if the value of your account continues to slide until January. However, if stocks rebound and your account value goes back up, then you would come out ahead by converting now because you'll owe taxes on a smaller balance.

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The decision is difficult because nobody knows what will happen to the market. But there is a way to hedge your bets.

If your account value has declined, you can convert a traditional IRA to a Roth now, then see what happens over the next few months. If the value of the account starts to increase, then you made the right choice. Even though you’ll owe taxes on the conversion when you file by April 15, 2009, your bill will be smaller than it would have been if you had waited. And any gains after you convert to a Roth will grow tax-free for retirement.

But if the account value continues to shrink, then you can undo your Roth conversion through a process called recharacterization. You have until October 15, 2009, to ask the IRA administrator to switch the Roth back to a traditional IRA. If you make the change before April 15, 2009, you won’t have to report the conversion. See Undoing a Roth Conversion for more information.

After a recharacterization, you have to wait at least 30 days or until 2009 to reconvert to a Roth, whichever is later. But at that point, you can convert to a Roth based on the shrunken value and pay a smaller tax bill in the future.

You can convert to a Roth only in a year when your adjusted gross income is $100,000 or less (whether married or single). See How to Lower Your Adjusted Gross Income for tips on how to stay below that limit. And anyone can convert a traditional IRA to a Roth in 2010, when the income limit disappears.