Only the first question is easy. The traditional IRA allows you to sock money away and get an immediate 
tax deduction. But when you eventually withdraw the funds, you pay tax.

The Roth, in contrast, gives you no deduction stepping in, but you pay zero tax when taking the money out. In other words, the traditional IRA offers tax-deferred growth; the Roth offers tax-free growth.

The ability to convert from the traditional to the Roth is nothing new. That’s been allowed since 1998. As of January 1, 2010, however, there is no longer a $100,000 income cap on who can convert to a Roth. Now anyone can. All you have to do is pony up the taxes due. But just because you can convert does not mean that you should.

“For many people the conversion can make enormous sense. For others it can be a disaster,” says Robert Keebler, CPA, MST, a partner in the accounting firm of Baker Tilly Virchow Krause, LLP, in Appleton, Wisconsin.

Which group are you in? Here’s how to tell:

Will your future tax rate go up?

With the federal debt mounting and personal income tax rates lower than they’ve been in decades, taxes overall are likely to rise. But what about your personal tax bracket? That is perhaps the single biggest consideration in deciding whether to convert.

“If you are paying 30 percent in taxes today, or 30 percent tomorrow, you are, in a strict mathematical sense, going to be no better or worse off by converting,” says Keebler. If you expect your taxes to rise in future years, however, you are a good candidate for conversion. If you expect your taxes to fall, which might be the case for a highly paid professional looking to retire soon, the conversion will probably not make sense.

When will you need the IRA funds?

The longer you have before tapping the funds, the more the Roth can grow tax-free and the more the conversion will help secure your nest egg. If you plan to use the funds within the next three to seven years, converting to a Roth probably won’t work to your advantage, says Keebler. If, on the other hand, you plan to not touch the money for decades, or perhaps never touch the money—leaving it to your kids, for example—the Roth conversion may add substantially to family wealth, he says.

Do you have the cash to pay the taxes now?

If you convert, say, $20,000 of your traditional IRA to a Roth this year (you can choose to convert all or part of your traditional IRA), you will likely owe income taxes (both federal and state) on the $20,000. If you are in the 30 percent total tax bracket—assuming the $20,000 doesn’t push you up into a higher tax bracket—you’ll have to cough up an extra $6,000 ($20,000 x 30 percent) by tax time. Or, you can take advantage of a special law currently in effect that allows you to defer recognizing the conversion income until you file your 2011 and 2012 tax forms. “Either way, the conversion will be more advantageous if you have the cash outside of your IRA to pay the tax,” says Scott Jacobsmeyer, CFP, president of Argent Wealth Management in Round Rock, Texas. In addition, he warns, if you pay the tax due out of the IRA and you are not yet 59 1/2, you may be subject to a 10 percent penalty.

Fortunately, you don’t need to figure this all out today. To convert for tax year 2010, you need to make your move by the end of December. And there’s always next year … and the year after that. “In fact,” says Jacobsmeyer, “for many people, partial conversions over a number of years (so you’re not taking too big a tax hit in any one year) might be the best strategy of all.”

Should You Convert Your IRA? The Saturday Evening Post

A rash of media stories called for abandoning the diversified portfolio, rejecting buy-and-hold investment, or adopting new tactics, such as market timing (jumping in and out of the stock market in the hopes of buying low and selling high) and cherry-picking (banking on one or possibly a handful of investments that you think will do better than all the others out there). Other stories have advocated just keeping your money under the proverbial mattress.

Investors are listening. According to the investment resource Morningstar, $573 billion in cash flowed into low-yielding but secure money-market funds in 2008 when the stock and bond markets (other than Treasury bonds) were suffering the most. As soon as the stock and bond markets started to come back in 2009, so did the investment money.

We’re here to tell you that you might want to think twice before following the pack and abandoning the tried and true—the well-diversified, broad portfolio of stocks and bonds and cash that you pretty much buy and hold—and jumping onto any bandwagon that promises to do better. Here’s why:

1. Cash is costly. Keeping your money in cash (money-market funds, savings accounts) may spare you from market volatility, but in the long run, the return on a diversified portfolio of 60 percent stocks and 40 percent bonds still clobbered cash. According to Morningstar, the respective 30-year returns on the diversified portfolio, after accounting for inflation, were three to four times that of a portfolio held in cash.

2. Markets are unpredictable in the short run. If you’re thinking that you’re going to keep your money in cash and pop into the markets at just the right time, think again. Pro investors often can’t even time the markets, says Cathy Pareto, MBA, CFP, president of Cathy Pareto & Associates, a wealth management firm based in Coral Gables, Florida. “Studies show that investors who buy and hold a diversified portfolio, rather than try to rush in and out of investments, tend to do much better.”

3. Specific winners and losers are unpredictable, too. If, instead of diversifying your portfolio, you try to zero in on individual securities or small segments of the market, you may be adding to your risk, but not your return. “People are often overconfident in thinking they can pick one stock or perhaps one industry that is going to do well,” says Don Bennyhoff, CFA, a senior investment analyst at Vanguard Investments. “Professional investors often do a very poor job when they attempt such picks—the average investor won’t even do that well.”

4. Costs are bigger than you think. When you buy and sell (whether popping in and out of the market, or gambling on individual stocks or market sectors) there are substantial costs involved, says Bennyhoff. The “spread” (the middleman’s cut) on stocks can be as high as several percentage points. There is often a commission or markup to pay the broker on any trade of a stock or bond, and fees on fund swaps are not uncommon. You may also pay higher taxes on a shifting portfolio than on a buy-and-hold one.

5. Look at the bottom line. The downturn of 2008–2009 was unusual in the manner in which so many investments, and entire classes of investments, turned sour at the same time. Still, diversification paid off, assures Bennyhoff. Bonds overall didn’t do quite so bad; some bonds, namely Treasuries, did very well. Certain segments of the stock market even shot off like rockets in the second half of 2009. Overall, if you had a highly diversified portfolio of 40 percent bonds, 30 percent U.S. stock, 20 percent foreign stock, and 10 percent cash, your portfolio on September 30, 2009, would have earned you 4.25 percent annually, or 51.63 percent cumulatively, over the prior decade. “Despite what you may have read, diversification and patience hasn’t entirely let us down,” says Bennyhoff.

Russell Wild, MBA, is a NAPFA-registered financial advisor who has written nearly two dozen books, including Index Investing for Dummies and Bond Investing for Dummies.

Why It Pays to Diversify The Saturday Evening Post