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Stiff the IRS for the Next 100 Years

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Many investors haven't had access to one of the best ways to save for retirement. Next year, however, everyone may 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:

  • Some believe that the Obama administration will look to implement tax hikes beginning if 2011. 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, current law allows you to spread your tax liability out across the 2011 and 2012 tax years. In subsequent years, you have to include that income in the same year you do the conversion
  • Unlike traditional IRAs, you never have to take withdrawals from your Roth IRAs if you don't want to. 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  )

$169,178

$59,212

Disney (NYSE: DIS  )

$747,000

$261,450

Hewlett-Packard (NYSE: HPQ  )

$1,095,294

$383,353

Caterpillar (NYSE: CAT  )

$139,406

$48,792

Boeing (NYSE: BA  )

$843,617

$295,266

Coca-Cola (NYSE: KO  )

$985,918

$345,071

Alcoa (NYSE: AA  )

$104,944

$36,730

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 to 60 years could 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. Coca-Cola is also a Motley Fool Income Investor pick. 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 (14)

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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 July 13, 2009, at 4:23 PM, rockendroll wrote:

    Wouldn't converting traditional to ROTH right now also be advantageous simply because of the current market decline?

  • Report this Comment On July 15, 2009, at 12:00 PM, chali2na wrote:

    Huh?

  • Report this Comment On July 15, 2009, at 12:01 PM, chali2na wrote:

    You mean, because everyone's portfolio is in the crapper and converting money worth less means less taxes? Talk to me lb

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