Starting January 1st, no matter how high your income is, you can turn a traditional, SIMPLE, or SEP IRA into a Roth IRA.(1) Why bother? Because once under the Roth “umbrella” your investments will grow tax-free instead of tax-deferred. That is, you won’t pay any income tax on the money- or the earnings on it- when you pull it out in retirement. There are a host of additional reasons which I covered in last week’s column.

Converting requires that you pay income tax on any contributions that you were able to deduct as well as the earnings your investments have generated up to now. However, this isn’t an all-or-nothing proposition. If you prefer, you can convert just some of your non-Roth assets.

For instance, you might want to spread your conversions over several years to make paying the tax more manageable. Since the taxable portion of the amount you convert is added to your income, you also want to be aware of your tax bracket; converting too much in a single year could push you into a higher one.

Normally you have to declare the converted amount as income -- and pay tax on it -- in the year you switch your assets into the Roth IRA. However, conversions completed in 2010 [only] allow you to postpone declaring the converted amount as income. Instead, you would add 50% to your 2011 tax return and 50% to your 2012 return. You’ll still have the option of declaring the entire amount as 2010 income, however. Such as, you think your income tax rates might be headed higher. (Did someone mention “ballooning federal deficit?”)

The problem is, like so many issues surrounding IRAs, Roth conversions are not as simple and straightforward as one would hope. The math can be tricky.(2) Allow me to illustrate.

Let’s assume that 42-year old Mark has only one non-Roth IRA: a traditional IRA that is worth $80,000. $24,000 of this represents annual contributions Mark has made. Since his income has been modest, he has been able to deduct all of these when he filed his income tax returns.

Next year Mark would like to convert half of the money in his traditional IRA ($40,000) to a Roth IRA. How much of this will he have to declare as income and pay tax on?

Step #1: Add up the current value of all non-Roth IRAs:
$80,000

Step #2: Total the money in non-Roth IRAs that has been previously taxed.
For Mark, this is $0.

Step #3: Divide the amount in Step #2 by the amount in Step #1 to determine what percentage of the non-Roth IRAs has already been subject to income tax.
$0 = 0%
$80,000

Step #4: Multiply the amount you wish to convert by the percentage in Step #3 to determine how much of this will not be taxed.
$40,000 x 0% = $0

Step #5: Subtract the answer in Step #4 from the amount you wish to convert:
$40,000 - $0 = $40,000

In this example, since Mark has not paid income tax on any of the money in his traditional IRA has will owe income tax on 100% of his conversion.

Unfortunately, in real life many people have IRAs in a number of different accounts, making the math a lot more complicated. These may include contributions that were tax-deductible as well as those made on an after-tax basis, i.e. they were non-deductible (generally because your income was too high).

Take 58-year old Margie. She’d like to convert $75,000 of the assets in her non-Roth IRAs. Here’s what she owns:
SEP IRA worth $30,000. All contributions were made by her former employer and were tax-deductible.

Traditional IRA worth $120,000. Margie deducted some of them, but when her income exceeded the limit, she could only make after-tax contributions. These total $40,000.

Roth IRA worth $20,000. By law, Margie paid income tax on all of her contributions ($12,000). The $8,000 and all future earnings will be withdrawn tax-free when she retires.

Since Margie wants to convert $75,000 to a Roth IRA, she could take this entire amount from her traditional IRA, which is worth $120,000. And, since she has already paid tax on some of the money in this IRA, she assumes this will reduce the amount of tax she’ll have to pay.

That would be a big mistake.

Although the assets to be converted can come from one non-Roth IRA or from several, by law, Margie must take all non-Roth IRAs into account when she calculates the tax consequences.

Following the same steps that Mark took, let’s figure out how much of the $75,000 Margie converts will be subject to income tax:

Step #1: Total non-Roth IRAs:
$150,000 ($30,000 + $120,000)

Step #2: Total after-tax money in non-Roth IRAs:
$40,000

Step #3: Percent of non-Roth IRA assets on which taxes have already been paid:
$40,000 = 26.7% 

$150,000

Step #4: Amount of converted dollars that will notbe subject to income tax:
$75,000 x 26.7% = $20,025
Step #5: Conversion amount that Margie will owe income tax on:
$75,000 - $20,025 = $54,975

If Margie completes her Roth conversion in 2010, she has the option of adding all $54,975 to her 2010 income or declaring half that amount as income in 2011 and the remainder in 2012.

If a Roth conversion seems like more trouble than it’s worth, consider this:
Suppose Mark’s $40,000 Roth IRA earns 6% per year. Even if he doesn’t add anything more to this account, when he retires at age 67, it will be worth nearly $172,000. And every cent can be withdrawn tax-free.

Let’s say Margie’s Roth also earns 6% per year. In 8 years when she retires, the $75,000 in her Roth will have grown to more than $119,000.

However, unlike non-Roth IRAs and retirement accounts such as 401[k]s, there are no required withdrawals from a Roth IRA when you reach age 70. If Margie or Mark has other sources of retirement income, the investments can simply be left in their Roth IRA and will continue to enjoy tax-free appreciation. When he is 75, Mark’s Roth will be worth nearly $275,000.

Assume that in Margie’s case, she never needed to tap her Roth IRA during her retirement and named her daughter as her beneficiary. When Margie dies at age 86, her account is worth roughly $383,000- money available to her daughter tax-free.

Next week: one more potential wrinkle on the road to a Roth conversion.
1. Through this year, your “modified adjusted gross income” [MAGI] must be $100,000 or less in order to be eligible to do a Roth conversion.
2. There are other potential pitfalls, such as the penalty for withdrawing money from a SIMPLE IRA within 2 years.