One such opportunity is the "Roth conversion".  If you have a traditional IRA (one in which you got a deduction each time you made a contribution to the account), distributions from the account (presumably during your retirement) will be treated as taxable income.  Distributions from a Roth IRA are tax free.

You may convert all or a portion of a traditional IRA to a Roth IRA and make future distributions tax-free, but there is a cost:  The amount of the conversion is taxable income in the year of the conversion.

There are three reasons why the conversions are at the forefront of tax planning strategies this year:

• There have always been income limitations that prevented many people from making the conversions.  Those limitations go away in 2010.
• It is good planning to make conversions when income is down and you can report the income from the conversion in a low-tax  bracket.  Many people's incomes are down in this economy.
• For IRAs converted in 2010, the income can be reported in 2010, or 50% in 2011 or 2012.

On the other hand,

• The tax rate you'll be paying in your retirement is uncertain.  Your lower total income may make your rate lower than what you'd pay now.  In addition, the tax rate you will pay on the converted amount in 2010-2012 is also uncertain. The tax rates may rise as governments struggle with balancing their budgets.
• Money you pay in taxes now reduces the money you can compound in your investment accounts.  Of course, no one knows what the market returns on your investments will be.

For most of the scenarios we have run — making moderate assumptions on tax rates and market returns — the income difference in retirement between a Conventional IRA and converted Roth has been minimal.

However, we suggest that you schedule an appointment with a Certified Public Accountant or other professional to see what a Roth conversion would mean in your specific circumstances.  In addition, we can adjust the forecasts with your personal assumptions on future tax rates and market returns.

Don't Forget the Five-Year Rule

To be qualified as tax-free, the distributions of Roth earnings must meet a five-year holding period test.  The five-year test for tax purposes begins on the first day of the taxable year for which the first contribution is made.  For penalty purposes, each conversion mast take into account a new five-year test.

A taxpayer's five-tax-year period begins with the first tax year for which the individual or their spouse makes a contribution to any of their Roth IRAs.  Note: This is one of the few instances in which a spouse's activities (along with the threshold tests for the active participations rules) makes a difference in the IRA rules.  For most IRA purposes, spouses are treated separately.

Example of a Five-Year Start Date

Joe opens a Roth account and makes a conversion contribution of $20,000 in February, 2009, then makes regular contribution of $3,000 for the 2009 tax year on April 15, 2010.  The five-year period for the regular contribution (and, therefore, for the Roth account) begins on January 1, 2009.