I am an italian citizen who worked in the US for 5 years on a H1-B visa. I will be going back to Italy for good at the end of March 2006 and I want to rollover my 401k to a Roth IRA (through a direct rollover IRA). The amount in the 401k is around $40,000. My income for 2005 was $49,000.

If I transfer the money to a Roth IRA before I leave, will I still have to deduct state and city taxes when I rollover to the Roth IRA (I reside in NYC)? What if I file as an italian resident, will I avoid state/city taxes?

Yes, the conversion to Roth is a taxable event for NY state and NYC taxes if you do it while you live in NYC.

Obviously, you should wait until you leave NYC if you wish to avoid the NY state/NYC taxes.

If you wait until you get back to Italy, you will avoid the NY-based taxes. However, you may have to pay Italian taxes (I cannot say for sure as I do not deal with taxes in Italy; suggest you seek guidance from a Italian tax professional).

Interesting. Which federal tax bracket will be applied to my 401k if I convert to a Roth IRA this year? I only have Jan and Feb pay stubs for less than $8,000 total. Assuming I'll have no job in Italy until 2007, will that set me in the 10% federal tax bracket?

No, the $40,000 distribution will put you through the 15% bracket and squarely into the 25% tax bracket.