If you have adjusted gross income below $100,000 (that qualifier disappears in 2010), you are eligible to switch your traditional IRA to a Roth IRA. In a traditional IRA you make pre-tax contributions and pay ordinary income tax upon taking the distributions in retirement; in a Roth IRA, you make after-tax contributions but your money grows tax free and you owe no tax upon taking distributions. To convert, though, you must first pay income tax on the full amount being shifted. The ideal candidate for this move is someone who has lost a job or otherwise suffered a steep income drop but expects to get back on track and be earning much more in the near future — like, say, a mortgage broker or SUV salesman. Your temporary setback gives you a temporarily low tax rate. If you wait until next year, not only might you be earning more money and be in a higher tax bracket, but income tax rates may be higher too, pushing up the cost of the conversion.
If you converted to a Roth IRA earlier this year and since then have seen your assets plummet you can undo the conversion, advises Doris Merrick, tax director at Brinton Eaton Wealth Advisors. Simply send the assets back to a traditional IRA (what's left of them), and start the process all over again. It's worth the effort. A $100,000 conversion early last year triggers a $35,000 tax liability for someone in the highest bracket. But they may be able to cut that liability dramatically. Say IRA assets plunge by 40% to $60,000. Undoing the conversion, and then reconverting, would avoid tax on $40,000 — roughly a $14,000 savings in this example.