To Roth or not to Roth – that is the question.

This year (2010), the income limitations to convert retirement plan balances to a Roth IRA have been eliminated.  Anybody, regardless of income, can now convert from a tax-deferred retirement option to a tax-free plan.

The price you pay is that any deferred income becomes taxable. Congress is desperate for additional cash flow. The carrot it has dangled is that any income recognition from the conversion in 2010 can be deferred and reported 50% on your 2011 and 50% on your 2012 tax returns. Alternatively, you can pay the full tax on your 2010 return if you expect your marginal rate to go up in 2011 and 2012. You can’t spread the tax over the three years, 2010, 2011, and 2012. Sorry.

Should you convert?

The Roth is clearly the more favorable option. Once you convert, all future income is tax-free. There are no minimum distributions for the original Roth investor. If the money is not needed for retirement, it can go to your beneficiaries who could withdraw a tax-free income stream over their lifetimes.

The younger you are, the more powerful the Roth conversion becomes. You now have more years of tax-free accumulation before you. If you expect the tax rates to go up, the advantage of conversion is magnified. Frankly, given the way Congress is spending trillions of dollars it doesn’t have, I can’t see the rates going anywhere except up.

The older you are, the less incentive you have to convert. All other things being equal (which they never are), my general rule of thumb is if you’re 40 or younger, convert, especially if you don’t need the retirement money to pay the added tax. If you’re over 60, you probably shouldn’t. You’re too close to retirement to make up for the immediate loss of the tax dollars. Moreover, the added income will expose any Social security receipts to potential taxation and can increase your Medicare Part B premiums by as much as $3,000 a year per person.

If you do convert, let’s do it right.

Consider using separate Roth IRAs for different asset classes. This gives you maximum flexibility if some of your assets crash while others appreciate. You’ll have until October 17, 2011, to decide whether to switch back your underperforming assets tax- and penalty-free.

Related reading:

• Borrow $100,000 tax-free from Social Security
• Profit by investing your home equity
• It’s not that hard to pay zero taxes