Your finances: converting an IRA to a Roth

To Roth or not to Roth? As it turns out, you can sort of have it both ways.

You can convert a traditional individual retirement account (IRA) -- with taxes deferred on the deposits and income tax paid on the withdrawals in retirement -- to a Roth IRA, where instead taxes are paid up front and no income taxes will be due again. And if it doesn't work out for you in terms of the tax burden or losses in the account, you can change your mind, because of some generous do-over clauses.

Here are six key issues to consider about whether to convert or not:

Remember your taxes
Convert only if you can pay the tax bill from outside your retirement accounts; otherwise, you're just eating away at your savings. Depending on your tax rate and what assets you're converting, that tax hit could be a third of the account's value or higher.

Timing is key
The longer you have until you need the money, the better the Roth conversion, thanks to the value of tax-free compounding. But timing isn't just about your age; it's about when you might need that money. The less likely you are to spend down your Roth in retirement, the more valuable it is.

Windfalls possible
While converting to a Roth may be worthwhile even if your income tax rate remains the same, it is an especially good deal if you expect your income tax rate to be higher in the future than it is now.

Restrictions not for all
While there are income limitations on funding a Roth (the phaseout starts at $107,000 for singles, and $169,000 for married filing jointly, for 2011), the removal of the income restrictions on converting to a Roth for those with modified adjusted incomes over $100,000 has led some financial planners to suggest that clients fund a nondeductible IRA and then convert it immediately to a Roth.

Be prepared at tax time
Special considerations for this year's tax returns: If you converted any IRAs to Roths in 2010 and took advantage of the special rule allowing you to spread the tax due over two years, you'll owe half the tax on this year's return. If you converted in 2011, you'll also owe tax on that conversion at this tax season since there was no special two-year tax deal in 2011. Don't let this come as a nasty surprise at tax time.

When investments decline
The Internal Revenue Service allows you to undo your conversion in a process called "recharacterization." The biggest reason to recharacterize a Roth is if your investments go south. Say, for example, that you converted a $100,000 deductible IRA to a Roth, and the investments in it declined by 20 percent. You'd owe tax on the full amount, even though your holdings are now worth only $80,000. Ouch! To avoid that outcome, you simply recharacterize the account with your financial institution; the deadline for undoing 2011 conversions is Oct. 15, 2012.