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A Tax-Savvy Way to Profit From the Panic

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Another day, another drop in the markets -- and your stock portfolio. Yet if you're looking for a silver lining from the declines, there's a big one -- one that could benefit you for the rest of your life.

Despite all the bad press that financial innovation has gotten in recent months, one technique that's just 10 years old has helped millions of retirement savers get on the road to achieving their financial goals. And if you've seen your retirement accounts lose a bunch of value this year -- as many have -- then you may be able to take advantage of this strategy to save thousands in taxes.

10 years of tax-free savings
Roth IRAs first came onto the scene in 1998. They pioneered a new way of saving for retirement. Before Roth IRAs came around, savers essentially had two choices. You could put money in a regular taxable mutual fund or brokerage account, paying taxes on your investment income every year, and racking up more tax liability when you sold your shares after their value had risen.

Or, you could set money aside in special tax-deferred accounts. Traditional IRAs gave you complete flexibility, but they also came with relatively low contribution limits -- $1,500 per year when they were first made available, and up to $5,000 currently. Employee 401(k) plans, on the other hand, have much higher annual contribution limits -- $15,500 in 2008 -- but with a catch: You're stuck with whatever investment choices your employer provides. Both of these options keep you from paying tax on the income you've earned until you take it out of the account, potentially giving you decades before you have to pay a penny of tax.

Read my lips: no taxes, ever
The Roth IRA, on the other hand, takes taxes out of the equation entirely. Unlike traditional IRAs and 401(k) plans, you don't get any sort of upfront tax break for making contributions to a Roth IRA -- you have to use after-tax money. But in return for giving up that tax deduction, you never have to pay income tax on the income from your Roth investments, even when you take the money out during retirement.

You can get into a Roth in two ways. First, you can make annual contributions. But the quicker way to get a lot of money into a Roth is by converting an existing traditional IRA or 401(k) account. You're eligible to convert if your income comes in under the $100,000 IRS limit.

Why now's the time
The bad thing about converting to a Roth is that you have to pay income tax on the amount you convert. It may seem silly to pay taxes when you don't need to. But there are a couple of reasons why converting now could be smart.

First, there's a strong possibility that tax rates will go up in the near future. Many current tax breaks expire after 2010, unless they're renewed. New taxes on investments may rise. If you're eligible for a low rate now, it could be cheaper in the long run to give up tax deferral and pay the tax now.

More importantly, though, with portfolio values down, you'll pay less tax than you would have. Consider, for instance, the tax cost of converting a sample stock portfolio with 500 shares each in several companies now versus 10 years ago:

Stock

10-Year Total Return

Tax Cost to Convert in 1998

Tax Cost to Convert Now

Citigroup (NYSE: C  )

(24.8%)

$2,183

$1,466

Ingersoll-Rand (NYSE: IR  )

(17.4%)

$2,715

$2,001

Home Depot (NYSE: HD  )

(24.7%)

$3,515

$2,364

Yahoo! (Nasdaq: YHOO  )

(26.9%)

$2,218

$1,448

Coca-Cola (NYSE: KO  )

(26.3%)

$7,788

$5,126

Alcoa (NYSE: AA  )

(41.2%)

$2,153

$1,130

Bristol-Myers Squibb (NYSE: BMY  )

(48.5%)

$5,048

$2,320

Source: Yahoo! Finance; 1998 share numbers adjusted to less than 500 for splits. Uses tax rates of 28% for 1998 and 25% for 2008.

As you can see, even on a relatively modest portfolio worth about $63,000, you'd pay almost $10,000 less in taxes by converting at market lows now versus 1998.

Run the numbers
So, if you're eligible to convert an IRA to a Roth this year, add it to your list of end-of-year strategies to consider. As with most tax matters, it's worth talking to a professional to make sure adding more income doesn't have unintended consequences.

But for many, a Roth IRA conversion now is a good idea. But if you wait until the market recovers, you may well miss out on a great opportunity to cut your taxes forever.

For more on investing in today's markets, read about:

IRA planning is just one element of a successful retirement strategy. To add in the other pieces you need to succeed in retirement, check out the Fool's Rule Your Retirement newsletter. You'll learn what you need to know about every aspect of retirement investing. Sign up now for a risk-free 30-day trial.

Fool contributor Dan Caplinger has maxed out his Roth IRA every year since they were created. He doesn't own shares of the companies mentioned in this article. Coca-Cola and Home Depot are Motley Fool Inside Value selections. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is never scared.


Read/Post Comments (5) | Recommend This Article (23)

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 October 28, 2008, at 2:40 PM, Brettze wrote:

    Suppose I convert my IRA and keogh accounts to Roth this year.. I have thousands in capital loss already... Will my capital losses reduce the tax I owes on my IRA conversion to Roth?

    pls reply to brettze@aol.com, thanks

  • Report this Comment On October 28, 2008, at 2:42 PM, Brettze wrote:

    Can the tax software do that for me? on capital loss versus IRA conversion to Roth? I use Tax Cut... If it is doable, pls inform TaxCut to update its software for 2008, thanks...

    pls reply to brettze@aol.com, many thanks!

  • Report this Comment On October 28, 2008, at 2:43 PM, Brettze wrote:

    Tax softwares usually dont remember my washsales and tax loss carryovers from prior years. I had to do it manually and red flags still wave!!

  • Report this Comment On November 13, 2008, at 2:26 PM, captainjgc wrote:

    i talked to my accountant today and she told me, if my balance is less than my original contributions (pretty sure it is - i'm 32 and have only been contributing for 4 or 5 years) i would have to add the original amount of my contributions to my agi, not the current balance - since that's the original sheltered amount. can this be true? seems really crazy!

  • Report this Comment On February 14, 2009, at 12:34 PM, ThosMN wrote:

    Sometimes Fools collide. Some Roth IRAs ARE subject to tax, and at higher rates than you'd pay on ordinary income. See, e.g.,

    http://www.fool.com/taxes/2000/taxes000908.htm

    which contradicts the above article (A contradiction? From a Fool? Huh?)

    I invest only in tangible assets I can see, which minimizes the chance that strangers like Jack Madoff will run off with my money. I discovered the Roth IRA tax issue when using a Self-Directed IRA to buy rental and specuative real estate through an IRA-owned LLC. Any rents collected and capital gains earned are subject to UBTI/UBIT at "trust rates" which kick in almost immediately. A word to the wise...

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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