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A Roth IRA Loophole

Here's a problem that some fortunate people have: If they earn more than $110,000 as an individual or have more than $160,000 in annual income as a married couple, they're likely prohibited from contributing to a Roth IRA. Bummer, eh?

It is a bummer for them, though, because Roth IRAs can be powerful ways to sock money away for the future. After all, funds contributed to a Roth IRA grow unfettered until you withdraw them -- tax-free! (Learn all about different kinds of IRAs in our IRA Center.)

Imagine that you invested $10,000 in Wal-Mart (NYSE: WMT  ) stock in your regular brokerage account 20 years ago. It would have grown some 17-fold, advancing by an average of 15% per year and growing to a total of around $173,000. If you ended up paying a capital gains tax rate of 15% on that upon withdrawal, you'd pay nearly $26,000 in taxes. If such an investment had been in a Roth IRA instead and you followed the rules, you'd be able to withdraw that money tax-free. It's a big difference.

But wait -- all is not lost for those high-earners. There's a new loophole they may be able to take advantage of. Beginning in 2010, they (anyone, really) will be able to convert a traditional IRA into a Roth IRA. So between now and 2010, wealthy savers can contribute to a traditional IRA and in 2010, by paying taxes on sums that had been enjoying tax-deferred status in the account, can transform that account into a Roth. How much can they sock away? Well, here are the limits for those 49 and under and those 50 or older:

Tax year(s) Under 50 50 or older
2006-2007 $4,000 $5,000
2008 $5,000 $6,000
2009-2010 indexed to inflation indexed plus $1,000

Are there any catches or downsides to this? Well, yes. For one thing, by the time 2010 rolls around, the loophole may be gone. (You'd still have valuable savings in your traditional IRA, though.) Also, if you expect to be in a very low tax bracket in retirement, then you won't be saving quite as much via a Roth IRA, though it will still be valuable to you.

Here's another wrinkle to consider. Even traditional IRAs have some limitations. If you're a participant in a qualified pension, profit-sharing or deferred compensation plan, and your income is over a certain amount, the sum you may contribute on a tax-deferred basis to a traditional IRA will face limitations. (If you're beginning to think you should consult with a tax pro in order to plan this all correctly, that's not a bad idea. Get our advice on how to find good advisors.)

One last consideration is that even if you're prohibited from making tax-deductible contributions to a traditional IRA, you can still make non-deductible contributions -- and convert them to a Roth later at a low tax cost. Also, this loophole might possibly serve you well if you've accumulated some money in a traditional IRA already.

Do take some time to learn more about the magic of IRAs in our IRA Center. The following articles may also be of interest:

  • "Put Your IRA on Autopilot" -- Tim Hanson reveals what's in his IRA, such as Vanguard Total Stock Market VIPERs (AMEX: VTI  ) and Vanguard Emerging Markets Stock VIPERs (AMEX: VWO  ) .
  • "3 Costly IRA Mistakes" -- Rex Moore shares some impressive stock performance numbers for the likes of Nokia (NYSE: NOK  ) and Southwest Airlines (NYSE: LUV  ) .
  • "The Best Funds for Your IRA" -- Shannon Zimmerman points to the iSharesRussell Midcap Growth Index (AMEX: IWP  ) among other possibilities to consider for your IRA.

Wal-Mart is anInside Valuepick.

Longtime Fool contributor Selena Maranjian owns shares of Wal-Mart. The Fool has an ironclad disclosure policy.

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