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How to Tell If You Should Do a Roth Conversion

NEW YORK (TheStreet) -- Is a "Roth conversion" a smart move? That's one of those perennial issues with the incredibly annoying answer: Well, it can be, depending on your situation ...

Still, it's worth wrestling with, especially as the end of the year approaches. A conversion's chief benefit can be a smaller tax bite on your retirement investments, and for some investors it could be better to convert in 2013 than later. But the conversion doesn't make sense for everyone, so let's break it down.

IRAs, as most folks know, are retirement savings vehicles that come in two flavors. In the traditional IRA, your investments are likely to get an upfront income tax deduction. They face no annual income or capital gains tax while they remain in the account, a "tax deferral" that increases the gains from compounding. But when you make a withdrawal, generally after age 59.5, any money that has not been taxed before is taxed as ordinary income.

Roths don't get an upfront deduction on contributions, but all withdrawals are tax free. Also, you're not required to start deductions after turning 70.5, as you are with a traditional IRA.

The law allows investors to convert traditional IRAs into Roths to get that tax-free treatment on withdrawals. The catch: When you convert, the converted sums are treated as a withdrawal from a traditional IRA and you must pay income tax.

So the conversion boils down to paying tax now to avoid paying tax later. After the conversion, future investment gains will grow tax free, and you can leave the investments to compound as long as you want. Of course, the money used to pay the tax is no longer available to grow as an investment.

A key rule of thumb: If you do convert, pay the tax from some other source of funds so that the entire conversion will be reinvested to get the Roth's tax-free treatment. Otherwise, the tax bite can offset much of the long-term benefit of converting.

Another guideline: Because tax-free compounding is so essential, conversion generally pays off only if you have quite a few years before you'll withdraw from the Roth.

So who should convert and who shouldn't? The key is your best guess about the income tax rates you will pay in the future compared to those you pay now.

Conversion makes sense if you expect your rate to go up. You'd pay tax at today's lower rate to avoid tax at tomorrow's higher rate. Clearly, then, conversion does not make sense if your tax rate will go down.

If you feel conversion is a good strategy in general and think your income will be higher next year than this year, it could pay to convert before Dec. 31 rather than after. Keep in mind that the sum you convert is added to your income, so it can move you to a higher tax bracket.

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