For the past 12 years, clients could contribute to a traditional or Roth IRA. Both accounts present certain tax benefits that are attractive in some situations, but next year, the rules regarding Roth IRAs are going to change. This could be a boon for some well-to-do clients, who have been limited by their high incomes from taking advantage of Roths IRAs. And this should be an opportunity for advisors to contact clients for an IRA checkup.

Then again, whether one should choose a traditional IRA or a Roth IRA is a tricky calculation, and planners often fail to use a clear analytical framework to make that decision. In this article, I’ll provide a framework for understanding not just which kind of account to choose, but whether it makes sense to convert funds from a traditional IRA to a Roth IRA.

High-income earners, either single or married, with adjusted gross incomes of over $100,000 have been unable to convert assets from a traditional IRA to a Roth IRA. That restriction disappears next year and every year thereafter. Of course, clients who want to convert funds from a traditional IRA funds to a Roth IRA have to pay taxes on the amount to be converted, however providing they meet certain rules, they will never have to withdraw those assets or pay taxes on them if they do withdraw them.

There is also a one-time provision in 2010 that allows clients to spread their tax income from the conversion equally over the next two years, 2011 and 2012.

So should you advise your high-income earners to make the switch? Let's go over some Roth basics.

The maximum Roth contribution will still be phased out as modified AGI increases (in 2009 the limits are $105,000 to $120,000 for single taxpayers and $166,000 to $176,000 for married joint filers). So the real opportunity for wealthy clients involves converting from a traditional IRA to a Roth.

Both traditional and Roth IRAs allow the same maximum contribution ($5,000 in 2009, plus a $1,000 catch-up contribution for those over age 50). Note that any contribution to a traditional IRA reduces the contribution one can make to a Roth IRA. If you contribute $3,000 to a traditional IRA, you can only contribute $2,000 to any other IRA to avoid exceeding the $5,000 total contribution limit (before catch-up contributions).

THE FIVE-YEAR RULE

Contributions to a Roth IRA don't create any initial tax deduction the way a traditional IRA contribution does. After-tax contributions to a Roth IRA may be withdrawn at any time, free of any income taxes or penalties. Once all original after-tax contributions have been withdrawn, subsequent distributions are treated as coming from growth in the Roth IRA (unless Roth conversions have occurred, as discussed later).

In order for withdrawals of growth from a Roth to be tax-free, clients have to wait until the first day of the fifth year after the year the Roth IRA was set up. This is the so-called five-year rule (i.e., if you opened a Roth between Jan. 1 and April 15 of 2009 as a 2008 account, the five-year clock would start on Jan. 1, 2008). In addition, the taxpayer must be either over age 591/2, already deceased, suffering a permanent or total disability, or eligible for special first-time homebuyer treatment (for a limited dollar amount).

To the extent that a withdrawal of growth doesn't satisfy the five-year rule and one of the subsequent requirements, it will be subject to ordinary income taxes. Separately, a withdrawal of earnings (but not original contributions) from a Roth IRA may also be subject to the same 10% early withdrawal penalty as with the traditional IRA, unless an exception applies.

However, unlike traditional IRAs, the Roth has no requirement to begin distributions while the owner is alive. Nonetheless, traditional and Roth IRAs follow the same required minimum distributions (RMDs) for beneficiaries after the owner dies (although the post-death Roth IRA distributions may still be tax-free).

CONVERSIONS

Taxpayers can also increase their Roth IRA funds by completing a conversion of part or all of a traditional IRA to a Roth IRA. Technically, this is simply a rollover. The taxpayer has to report all pretax amounts as ordinary income.

A Roth conversion can also be reversed under the Roth recharacterization rules. A recharacterization lets you transfer back any assets that were converted from a traditional IRA to a Roth, but the recharacterization rollover must occur by the due date of the tax return for the tax year in question, including extensions. Any amounts rolled back must be adjusted for gains or losses that occurred during the intervening period. If completed in a timely manner, it's as though the conversion never occurred, and no Roth income is reported for tax purposes.