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 exceeds the applicable income limits -- $120,000 for singles and $176,000 for married couples in 2009 -- 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?
Usually, 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 1969, despite the current bear market:

Stock

$10,000 Invested in 1969 Is Now Worth:

Potential Tax Avoided

IBM (NYSE: IBM  )

$165,875

$58,056

Disney (NYSE: DIS  )

$616,765

$215,868

Hewlett-Packard (NYSE: HPQ  )

$1,075,455

$376,409

Caterpillar (NYSE: CAT  )

$188,030

$65,811

Boeing (NYSE: BA  )

$563,467

$197,213

Coca-Cola (NYSE: KO  )

$829,231

$290,231

Alcoa (NYSE: AA  )

$83,333

$29,167

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 next year rolls around. The new administration could kill the provision, or a general increase in income-tax rates could make conversions less attractive.

In addition, Congress could create new taxes on Roth accounts. That 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.

This article was originally published on May 29, 2008. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned in this article. Coca-Cola and Disney are Motley Fool Inside Value picks. Disney is also a Motley Fool Stock Advisor 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 (13)

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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 February 04, 2009, at 10:33 AM, fabfan97 wrote:

    hola MFs. I hope you can help me.

    I changed jobs in Feb 2008 and wanted to roll over my employer 401K into an IRA. when I approached my brokerage (where my Roth IRA is), I found out you could roll it into a Roth. that sounded great - one account, no need to open a new traditional IRA acct. I know I need to pay taxes on this rollover b/c Roth IRAs are funded with after-tax dollars.

    here is the problem. the 401K administrator sent me a 1099-R to report this rollover, and it says there is no taxable income (I know this is wrong) and the distribution code in box 7 is G, which is the "direct rollover of a distribution (other than a designated Roth account distribution) to a qualified plan, section 403b plan, a governmental 457b plan, or an IRA." I try plugging this into my tax software and naturally I get an error b/c the software is confused, *usually* direct rollovers are not taxable. but not in my case! I've called both the 401K administrator (they are refusing to provide a corrected 1099-R b/c they processed it as a rollover to a traditional IRA) and my brokerage, both of them are saying that I have to make do with the 1099-R I was given and that I have to consult a tax advisor.

    ideas? thanks in advance!

  • Report this Comment On May 05, 2009, at 1:07 PM, BlindLuck32 wrote:

    As far as I know 401Ks cannot be rolled over into a Roth IRA. They have to be rolled over into a rollover IRA, converted to a Roth IRA and then they can be combined with your existing IRA. Compare the dollar amounts on the 1099-R and the deposit history of your IRA. If they are not the same, its possible your brokerage completed the transfer and conversion in one step. (Unlikely but possible I guess) Its also possible your 401K was a Roth 401K in which case there is no tax in the transfer.

  • Report this Comment On October 29, 2009, at 12:14 AM, davecc wrote:

    Roth IRAs are the way to go and as you are saying, 2010 will be a great year to convert! here are a few other resources about Roth IRAs: www.rothirahelp.com and www.rothira.com

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