With the elimination of income caps, millions more investors will be allowed to convert traditional IRAs, 401(k)s and other “tax-deferred” retirement plans into tax-free Roth IRAs. But a growing number of news stories quote financial advisors speculating about a possible Washington double-cross that might someday make Roth’s taxable after all.

Should this possibility, which no lawmaker has proposed, really discourage you from doing a conversion that otherwise looks profitable? The worst-case scenario would surely draw the voters’ wrath, making it seem unlikely. Then again, you never know what Washington will do.

Key benefits of the Roth: Unlike a regular IRA, 401(k) or similar plan, withdrawals are tax free and you don’t have to start taking money out after turning 70 ½. Roths are generally better if you expect to leave money to heirs.

There is no tax deduction on money put into Roths, as there is with 401(k)s and many traditional IRAs. But the Roth can be more profitable for investors who have many years of compounding ahead of them, or who expect their tax brackets to be higher in retirement.
Unfortunately, the conversion option comes with a catch: You’ll have to pay income tax on any converted funds that have not been taxed previously, including investment gains and contributions to 401(k)s and tax-deductible contributions to IRAs.

The Roth IRA Conversion Calculator can help determine whether a conversion would make sense for you. Your broker and mutual fund companies probably have advice on their sites. T. Rowe. Price (Stock Quote: TROW) has some useful pointers on its site, for instance.

Recent news stories quote a number of financial advisors warning that a conversion could backfire if Washington someday imposes taxes on Roth withdrawals as a way of offsetting soaring federal deficits.

While no one knows what will happen, the worst-case scenario seems pretty unlikely. That would be to impose an income tax on withdrawals on top of the income tax paid just after the conversion. Taxing the same money twice would infuriate millions of voters.
If the rules were to change at all, another scenario, though still a dirty trick, seems more likely: taxing money that has not yet been taxed. The assets you had at the time of the conversion could still be withdrawn tax free, since you’d paid the conversion tax. But there would be a tax on investment gains earned after the conversion.

If this were to happen, the conversion would probably still have been worthwhile.

The effects of each scenario would depend, however, on a lot of factors, such as your tax bracket and investment return.

No matter what happens, a key rule of thumb would probably hold. It’s generally better to pay taxes when you’re in a lower tax bracket. That makes a conversion next year appealing because, given Washington’s money problems, it seems far more likely that tax rates will rise in coming years rather than fall.

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