Yes, it is the financial buzz of 2010: Covert your IRA or qualified retirement plan to a Roth IRA this year even if you earn over $100,000 annually. What’s so great about it?

1. Earnings on a Roth IRA accumulate income tax-free, unlike a traditional IRA whose assets grow tax deferred and on which you pay subsequent taxes when those assets are withdrawn, and;
2. There is no required minimum distribution at age 70 ½, unlike traditional IRA’s.

And, by the way, if you make the conversion this year you can choose to pay the taxes on the amount you convert over 2 years (2011 & 2012). Sounds like a great idea, right?

Well, maybe. There are several traps this conversion could cause you to fall into and which might require more than a bandage to fix it. Listed below are five of them.

Number 1 is about splitting the tax bill and it pertains to everyone. The tax itself is not split over 2 years, the income is split. Example: You want to convert $100,000 in an IRA to a Roth IRA in 2010. You will have to pay income tax on $100,000 assuming all of the contributions you made to the IRA were deductible contributions. Now you have 2 choices. The first is to add $100,000 to your taxable income for this year (2010). Or, you can add $50,000 to your taxable income in 2011 and $50,000 to your taxable income in 2012. The trap is that your total tax bill will depend on a ton of variables over the next two years, many of which may be out of your control, such as tax rates and overall income levels. Any little change could cost you way more than you expected.

Number 2 is for those of you who have young ones at home who are planning to attend college. Eligibility for financial aid is calculated from a number of factors. However, one the most critical factors is the parents’ income. The higher your income is, the less likely your child is to qualify. A Roth IRA conversion could create a spike in your income for the year or years where the income is included on your tax return. And, yes, it counts.

Number 3 is for those of you taking social security and using Medicare. You could be accustomed to tax-free social security benefits. However, depending on how much income you have (the income created by the Roth Conversion), anywhere from 50%-80% of these same benefits that were not taxed in the past could be included in your gross income, resulting in a higher tax bill. Moreover, your Medicare Part B premiums are based on income. A Roth Conversion, which will increase your taxable income, could move you into a higher premium bracket.

Number 4 is if you are 70 ½ or older this year. If you plan to convert your IRA to a Roth IRA, you still have to take a required minimum distribution (RMD) for 2010. This amount cannot be converted to a Roth IRA. Once you withdrawal your RMD for 2010, you then can convert the remaining IRA balance.

Number 5 is if you are 59 ½ or younger. You are probably already aware that if you withdraw money from an IRA before age 59 ½, there is a 10% penalty plus the taxes. One of the benefits to a Roth IRA is that there is no penalty for withdrawing the principal before age 59 ½ IF AND ONLY IF the funds converted are withdrawn after 5 years. Any money withdrawn before these 5 years or before you turn 59 ½ , whichever is sooner, still takes a 10% penalty. This also applies to using these funds to pay the tax initiated by the conversion.

These are just 5 of many traps a Roth conversion could trigger. We didn’t even begin to discuss different qualified plans, inherited IRAs, individuals taking 72(t) payments, partial conversions, after-tax and non-deductible contributions, etc. My goal today is to remind you that you really don’t know what you don’t know. And more often than not, it’s what you don’t know that will hurt you. Bottom Line: No matter what your situation is, a Roth Conversion requires working with a professional who does know.

VSR does not provide tax or legal advice.