Now that there are no income restrictions on who can convert to a Roth IRA, think about converting your after-tax 401(k) money if you are retiring soon or if your plan allows in-service withdrawals.

Traditional IRAs are tax-deferred retirement accounts, whereas Roth IRAs are tax-free, assuming your withdrawals are made after you reach 59 1/2 and that you’ve waited at least five years after setting up the Roth, deemed “qualified distributions.” To count the five years, start with Jan. 1 of the year of your first contribution to the Roth.

Logic would tell you that the conversion of money you contributed to your after-tax 401(k), considered your “basis,” should be tax-free when converted to a Roth IRA — after all, you’ve paid taxes on that amount. and, indeed, that is the case, if all you have is after-tax 401(k) money.

Let’s walk through an example, assuming you are 65 and about to retire, but let me caution you to make sure you check with your tax adviser before taking any action.

If you have no retirement accounts other than after-tax money in your 401(k), you can roll that over directly from your 401(k) to a Roth IRA tax-free, according to Mark Steber, chief tax officer of Jackson Hewitt Tax Service. if you contributed $25,000 to your after-tax 401(k) and that account is worth $25,000 or less, a full conversion will be tax-free — unless your situation is a little more complicated, as we’ll discuss.

It’s best to the rollover your 401(k) directly to a Roth IRA, which is permitted by the Pension Protection Act of 2006, which became effective after Jan. 1, 2008. Before that, you had to roll your 401(k) into a traditional IRA and then convert to a Roth IRA.

What if your $25,000 after-tax 401(k) earned $5,000? you could roll $30,000 to the Roth, but only $25,000 would be tax-free, Steber said. Rollovers of earnings on after-tax 401(k)s are treated as pre-tax money, which is taxable when converted to a Roth, according to Steber. Note that some advisers believe that earnings on after-tax money are not taxable, but that is not the case under current law.

Now, assume that you also have a pre-tax 401(k) balance of $70,000, bringing your entire 401(k) to $100,000. Can you isolate the after-tax money of $25,000 and only roll that over to a Roth?

That would be ideal, but the answer is no, according to Tom Foster of The Hartford Financial Services Group inc.

Why? The law considers a 401(k) withdrawal, and a Roth conversion is considered a withdrawal for tax purposes, to come pro-rata from pre-tax and after-tax money. So, if you want to convert $25,000 of the $100,000 401(k) to a Roth IRA, only $6,250 will be tax-free and $18,750 will be fully taxable when you do the rollover, according to Foster.

If you have more than one 401(k) plan, the pro-rata rules apply to each 401(k) plan separately. I should mention that certain 401(k)s may be set up as separate plans and that it may be possible to argue that you can rollover the after-tax money in a tax-free conversion without applying the pro-rata rule — you’ll need to check with your plan administrator and your tax adviser.

Now, let’s say you want to convert the entire $100,000 401(k) to a Roth IRA. To complicate matters a bit, let’s say you also have three traditional IRAs totaling $300,000 — all pre-tax. Do the IRAs have to be counted for purposes of the pro-rata rule?

The answer is yes and no. As long as you do a direct rollover of the $100,000 401(k) to the Roth IRA, the traditional IRAs don’t need to be considered, Foster said. The taxable portion of the $100,000 Roth conversion will be $75,000– $70,000 pre-tax plus $5,000 after-tax earnings.

But — and this is important — you get a different result if you rollover to a traditional IRA first and then do a conversion instead of doing a direct rollover from your 401(k) to a Roth.

Unlike the direct rollover from your 401(k) to a Roth IRA, of which $25,000 is tax-free, here, only $6,250 is tax-free. why? Under pro-rata rules that apply to traditional IRA conversions, you have to add your traditional IRAs to determine the taxable portion of the conversion, according to Foster.

Here is the formula: $25,000 divided by $400,000 — $300,000 IRAs and $100,000 401(k) rollover — equals 6.25 percent. The remaining $93,750 is taxable, according to Foster.

What’s the bottom line?

Anyone with after-tax 401(k) money should seriously consider doing a direct rollover to a Roth IRA — there is simply no better investment opportunity than a tax-free Roth IRA.

If the rollover can be done tax-free, so much the better.

But be sure to check out your situation carefully before proceeding. The law is evolving in this complicated area — plus there are differing opinions on how to apply the current law. Don’t skimp on tax advice, especially if you want to rollover a large amount.

For more information on rolling over a 401(k) to a Roth IRA, read IRS Notice 2009-68 and IRS Notice 2009-75, which you can find online at www.irs.gov.

Julie Jason, JD, LLM, author of “The AARP Retirement Survival Guide: How to make Smart Financial Decisions in Good Times and bad,” is a money manager and principal of Jackson, Grant Investment Advisers, inc. of Stamford. she welcomes questions for consideration in her column. please e-mail her at readers@juliejason.com or write to her c/o The Advocate and Greenwich Time, 9 Riverbend Drive, South, Building 9A, Box 4910, Stamford, CT 06907. Copyright 2010 Julie Jason.

Think Roth for after-tax 401(k)