As the year begins, this is an ideal time to convert a traditional IRA to a Roth IRA. The earlier in the year you convert, the better. Possible outcomes:
Your Roth IRA grows in value. In this scenario, you’re on your way to tax-free investment income. After five years and after age 59-1/2, all withdrawals from a Roth IRA escape income tax.
Your Roth IRA loses value. You can get a free do-over. For a 2011 Roth IRA conversion, you have until October 15, 2012, to recharacterize (reverse) the transaction. The money will go back into your traditional IRA.
It’s true that you’ll owe income tax on a Roth IRA conversion. After the conversion, though, all subsequent appreciation can be tax-free. And, if your account value falls, you’ll have from now until next October 15 to undo the conversion and avoid paying income tax.
You can improve your chances by splitting your Roth IRA into multiple accounts when you convert. One Roth IRA might hold stocks while another Roth IRA holds bonds, for example. If stocks rise and bonds fall, for instance, you can undo the bond Roth IRA and avoid paying tax on the bond Roth IRA conversion by recharacterizing. The stock Roth IRA, meanwhile, can be left in place with potentially tax-free appreciation.