Q: I just got something in the mail from my plan administrator that says I am eligible to convert my traditional IRA into a Roth IRA.  What is my plan administrator talking about, what is the difference between a traditional and Roth IRA, why would I convert?

A: Firstly, congratulations for having the foresight to fund an IRA Individual Retirement Account.
Generally, contributions to a traditional IRA may be tax deductable at the time the contribution is made, lowering a workers taxable income for tax purposes. The funds in a traditional IRA account grow tax-free until the time of distribution. Once the account holder begins to take IRA distributions, those funds are taxable at the account holder’s marginal tax rate. This is known as a tax deferred account, because payment of taxes is deferred until funds are withdrawn from the account.

Alternatively, with a Roth IRA, contributions to the account are not tax deductable and are generally made from the workers or workers spouse’s after tax or “take-home” earnings.  The funds in the Roth IRA accumulate and grow tax free, and are not subject to tax upon withdrawal.  Thus a Roth IRA offers tax free growth of retirement savings.

Starting in 2010, the income limit restricting eligibility to convert a traditional to a Roth IRA has been removed, thus anyone may convert part or all of their traditional IRA into a Roth by converting in 2010, and any resulting taxes can be spread over 2011 and 2012.

Remember, one’s tax liability on the income may differ depending on when you decide to recognize it. Because the conversion amount increases your taxable income, it could reduce the deductions or credits available to you in a given year. If the income is significant, it could potentially push you into a new tax bracket and you'd wind up paying a higher rate on at least some of the amount.

According to Joel Dickson of Vanguard's Quantitative Equity Group: individuals considering this strategy should also consider that, under the current tax code, tax rates are scheduled to increase after 2010. Therefore, if you elect to spread taxable income across 2011 and 2012, you may actually owe more tax than if you recognize the income in 2010.  "It's not clear that it would be a big advantage to spread your taxes into years where you might actually face higher rates," said Mr. Dickson.  If you convert to a Roth IRA in 2010, you'll at least have some time to make up your mind about how to handle any resulting tax bill; the deadline for making a decision about the 2-year option is your tax-filing deadline—April 15, 2011.

Sources
Vanguard.com
Bankrate.com