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Save More With a Roth IRA Conversion

If you've been shut out of opening a Roth IRA account, you may finally get your chance -- in a couple of years.

Anyone who has earned income can contribute to a traditional IRA. But Roth IRAs -- which offer the prospect of tax-free income rather than just tax deferral -- have income limits that apply to prevent high-earning taxpayers from creating them. Joint filers who have more than $169,000 in adjusted gross income for 2008 won't be allowed to contribute to a Roth IRA. For singles, the limit is $116,000. For those who make more than that, having a Roth has been an impossible dream.

Getting in through the back door
Even if you're not eligible to open a Roth IRA directly, there's another way in -- by converting a traditional IRA to a Roth. Conversions are actually potentially much more valuable for retirement savers than contributions -- while the maximum annual contribution is $5,000, you can convert your entire IRA balance if you want. But again, income limits apply. If you have gross income of $100,000 or more -- regardless of whether you're married or single -- you can't do a Roth conversion, either.

But that's all set to change in 2010. If the tax laws don't change between now and then, the $100,000 limit on Roth conversions will disappear in 2010, opening the floodgates for anyone who wants to convert their traditional IRAs.

Why does it matter?
At first glance, you might wonder why anyone would want to convert an IRA. While keeping your traditional IRA lets you defer your taxes until you retire, converting to a Roth forces you to pay tax immediately on the amount you convert. The 2010 provisions allow you to spread that amount out over the 2011 and 2012 tax years, but even so, you'll still have to pay tax as a result.

Even though a conversion forces you to pay tax, Roth IRAs have several advantages that may justify a current tax payment. First, while traditional IRAs force you to take minimum distributions shortly after you turn 70, Roth IRAs give you total control to take as little or as much as you want from your accounts throughout your lifetime.

Also, the taxes you pay upon conversion are the last taxes you'll pay on your Roth IRA assets. If you anticipate being in a high tax bracket during retirement -- a reasonable assumption for successful investors with considerable dividend and interest income -- then it can make sense to pay taxes now if you're being taxed at a relatively low rate. With tax rates low by historical standards, it may be best to pay smaller taxes now rather than bigger taxes during retirement.

Asset allocation across accounts
Last, having both traditional and Roth IRA accounts gives you the flexibility to divide your assets in the most appropriate fashion. For instance, investments that don't qualify for lower tax rates on dividends, including REITs like Simon Property Group (NYSE: SPG  ) and Equity Residential Properties (NYSE: EQR  ) , go well in either type of IRA.

But for dividend-paying stocks with growth potential, such as Coca-Cola (NYSE: KO  ) or Wrigley (NYSE: WWY  ) , putting them in a traditional IRA means you give up the tax advantages of the 15% maximum rate on dividends. Similarly, investments that have a real chance to grow by huge amounts, including Universal Display (Nasdaq: PANL  ) and Middleby (Nasdaq: MIDD  ) , are better placed either within a tax-free Roth IRA or in a taxable account that lets investors get the lower 15% capital gains rate.

So if you have money in traditional IRAs and think converting to a Roth might be a smart move for you, 2010 can't come soon enough. And even if you've been locked out of the Roth IRA for more than a decade now, you'll find that it's definitely been worth the wait.

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Read/Post Comments (2) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2009, at 4:31 PM, wardw123 wrote:

    Dear Motley Fool,

    This article contains what seems to be a confusing fallacy: the suggestion near the end of the article that a person's return would be higher if they put a stock with significant future capital gains into a taxable account rather than a Traditional IRA or 401k.

    Mr. Caplinger says, "for dividend-paying stocks with growth potential, [...] putting them in a traditional IRA means you give up the tax advantages of the 15% maximum rate on dividends. Similarly, investments that have a real chance to grow by huge amounts [...] are better placed either within a tax-free Roth IRA or in a taxable account that lets investors get the lower 15% capital gains rate."

    Unless there's something I'm missing, this is flatly untrue (except in some special cases, the assumptions for which are not addressed in the article.)

    Let's see why this is plain wrong: Mr. Caplinger is (I believe) assuming we have an equal amount to invest in either a Traditional IRA or a taxable account.

    He seems to be saying that since ordinary income rates (let's say 25%) are typically higher than the long-term capital gains rate (say 15%), you will come out ahead if you put a stock into a taxable account versus a Traditional IRA (assuming no dividend growth, just capital gains.)

    HOWEVER, Mr. Caplinger neglects the fact that the Traditional IRA investor has ALREADY saved 25% in taxes by choosing the Traditional IRA over the taxable account. The trick is to remember to start with the same GROSS amount of income and THEN see what happens. If we start with $5000 in gross income, $5000 goes into the Traditional IRA whereas only $3750 (at 25% tax bracket) goes into the taxable account. After these amounts grow for several years, the taxable account is taxed AGAIN, this time at 15%, whereas the Traditional IRA is taxed ONCE at 25% (assuming the future rate remains the same.)

    Therefore, if 'before and after' ordinary tax rates are roughly equal, the taxable account can NEVER outperform the Traditional IRA, regardless of the type of security selected. (If the capital gains rate equaled zero, the two accounts would be equal, assuming no dividends. Taxed dividends would drive down the taxable account's return further since a Traditional IRA grows tax-free.)

    Note also that, if marginal tax rates for both contributions and distributions of the investment are identical, it makes no difference whether a person puts a stock in a Roth or Traditional IRA. (I.e.: it doesn't matter whether you take 25% off of your investment at the beginning or the end. If we assume an investment with a 10% return for 10 years, a $1 investment in either account will be worth 0.75*1.10^10 = 1.10^10*0.75. This is the commutative rule of multiplication. What matters is whether the marginal tax rate at which you put the money INTO the account is greater or less than the marginal rate when you take the money OUT.)

    Mr. Caplinger's assertion of taxable accounts outperforming Traditional IRAs would only be correct if current marginal tax rates ended up being lower than future ordinary income rates (and if capital gains rates stayed lower than ordinary income rate.) This is possible, but should be clearly stated as an assumption.

    Please either clarify or post a retraction to this article (granted this is 1 and a half years after the article was written, but still, people like me look to the Fool's archives for quality information long after it's originally been posted.)

    Thank you for taking the time to read this,

    Ward Williams

  • Report this Comment On April 28, 2011, at 4:32 PM, TMFGalagan wrote:

    Mr. Williams -

    Thanks for your comments. I think that any confusion stems from the fact that the article looks at the question from a different standpoint than your assumption. I assume that you already have money both in an IRA and in a taxable account and ask the question of which stocks go best in each account.

    With your assumptions -- basically, that you can only afford either a taxable account or an IRA -- I agree with your conclusions. The article simply addresses a different question.


    dan (TMF Galagan)

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