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Stiff the IRS for the Next 100 Years

Many investors haven't had access to one of the best ways to save for retirement. In a couple of years, however, everyone will have a chance to give the IRS a century-long vacation from collecting tax on their investments.

Roth IRAs give retirement savers the opportunity to invest money in nearly anything they want without having to pay taxes. Currently, however, those whose adjusted gross income is more than the applicable income limits -- $116,000 for singles and $169,000 for married couples in 2008 -- aren't allowed to contribute to Roth IRAs. An even lower limit -- $100,000 for everyone -- applies to prevent many people from converting traditional IRAs to Roth IRAs.

In 2010, the limit on Roth conversions is slated to go away. Although income limits will still apply to regular contributions, being able to convert money in old 401(k) accounts and traditional IRAs is worth a lot more than depositing a few thousand dollars every year.

Why pay tax now?
With a few exceptions, the smartest move is to put off paying income tax as long as possible. But if you decide to do a Roth conversion, you'll have to pay tax on the money you convert. So what's the big deal? Why pay more tax than you have to?

Even with the higher tax bill, there are some big advantages to doing a Roth IRA conversion:

  • Many are concerned that income-tax rates will go up sooner or later. If the current low rates still apply in 2010, then converting lets you lock in those low rates and avoids higher taxes later.
  • If you convert during 2010, you can spread your tax liability out across the 2011 and 2012 tax years. In subsequent years, you have to pay tax the same year.
  • Unlike traditional IRAs, Roth IRAs don't force you to take money out if you don't need it. That opens the door to a very effective estate-planning technique, where you can pass on your Roth IRA to your heirs, who can then enjoy tax-free distributions throughout their lives.

It's that last point that's the most powerful. Think about it: You enjoy tax-free growth for the rest of your lifetime. Then, if you leave your Roth IRA to your kids or grandkids, they won't pay income tax, either -- they just have to take withdrawals based on their life expectancy. Depending on how old you and your kids or grandkids are, that can easily add up to 100 years or more of dividends and capital gains -- all tax-free.

To get just a glimpse of how much you can save in taxes, go back 40 years and look at how some well-known stocks have performed since 1968:


$10,000 Invested in 1968 Is Now Worth:

Potential Tax Avoided




General Motors (NYSE: GM  )



Hewlett-Packard (NYSE: HPQ  )



Caterpillar (NYSE: CAT  )



Boeing (NYSE: BA  )



Coca-Cola (NYSE: KO  )



Alcoa (NYSE: AA  )



Source: Yahoo! Finance. Tax avoided is based on current maximum 35% rate that applies to traditional IRA and 401(k) distributions.

Then imagine what another 40 or 60 years would do to those values. With the huge tax savings that Roth conversions make possible, it's no wonder that high-income taxpayers are already planning for 2010.

Not a sure thing
But they're also keeping their fingers crossed. Unfortunately, there's no guarantee that conversions will still be available by the time 2010 rolls around. What happens in the 2008 elections could have a big impact, and even if the next administration doesn't kill the provision, a general increase in income-tax rates could make conversions less attractive.

In addition, Congress could change the tax laws to make Roth IRAs less attractive. It could create new taxes on Roth accounts. Alternatively, if the U.S. moved to a consumption-tax model, it would effectively eliminate the main benefit of Roth IRAs. Either of those scenarios would be disastrous if you converted, because you'd end up unnecessarily paying taxes twice.

For many, though, the potential rewards are enough to warrant taking some risk. With the possibility of much higher tax rates in the future, taking action to lock in lower rates could save you and your family millions over the next several generations.

For more on the Roth IRA:

If you like the idea of keeping the IRS on a leash, you'll want to take a close look at the Fool's Rule Your Retirement newsletter service. Our retirement service gives you plenty of ideas on how you can protect your savings from taxes. Check it out now with a free 30-day trial.

Fool contributor Dan Caplinger has his conversion plans all mapped out for the foreseeable future. He doesn't own shares of the companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is on your side.

Read/Post Comments (3) | Recommend This Article (8)

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 May 29, 2008, at 2:25 PM, aberdasher3rd wrote:

    Good article. Personally I plan on combining IRAs, 401b, etc before 2010 to be ready to move into my Roth, if that decision is made.

    Need more articles/information about the 2010 Roth conversion limit.

  • Report this Comment On August 20, 2009, at 5:34 PM, andys2i wrote:

    However new tax laws ( ) in 2010 are changing the conversion limit, meaning that people who have or are interested in investing for retirement via IRA’s need to look at which vehicle and contribution method (post or pre tax) is best for their situation.

    Next year, taxpayers making more than $100,000 a year in adjusted income will be allowed to convert to Roth IRA accounts from traditional IRAs. That means that more than 15 million Americans, can consider whether they want to make tax-deductible contributions if they have a traditional IRA or pay the taxes up front and have tax- free withdrawals during retirement with a Roth IRA. Which is better depends on future tax rates and how much the conversion will cost.

  • Report this Comment On September 13, 2011, at 8:14 AM, alex233 wrote:

    I don't keep more than 10-15% of retirement savings in a Roth because it depends too much on the integrity of politicians to keep it untaxed as promised.

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