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A Huge Opportunity Approaches

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On countless occasions, I've lamented that if only I'd known in the past what I know now, I could have avoided a mistake, or made a better decision. The best way to avoid those situations is to learn everything you can all the time.

Anyone who wants a regret-free retirement should start reading up on Roth IRAs. You can plunk your post-tax dollars into a Roth IRA and invest them in what you wish. When you withdraw your money -- along with all the income it has produced -- you'll do so tax-free. That could add up to a lot of money, as these familiar stocks can show you:

Company

CAPS stars (out of five)

20-year total return

Best Buy (NYSE: BBY  )

**

13,682%

Nike (NYSE: NKE  )

****

2,092%

Walgreen (NYSE: WAG  )

****

1,518%

ExxonMobil (NYSE: XOM  )

****

1,019%

Procter & Gamble (NYSE: PG  )

*****

964%

Deere (NYSE: DE  )

****

860%

General Electric (NYSE: GE  )

****

467%

Data: Yahoo! Finance, Motley Fool CAPS.

I don't mean to suggest that these companies will keep growing at these rates – but they do show you what kind of growth is possible, if you choose well. Imagine a $10,000 initial investment in Nike; over the past two decades, it would have grown to nearly $220,000. In a regular brokerage account, that $210,000 gain would be taxable, costing most of us 15% or $31,500. (Remember that tax rates may well go up in coming years to pay for our economic recovery -- a 20% tax hit on that sum would be $42,000.)

In a Roth IRA, though, if you follow the rules, you'll likely be able to take out the entire $220,000 tax-free. This is a powerful kind of retirement savings. Imagine hitting retirement with a $1 million Roth IRA account and a $1 million 401(k). Withdrawals from the 401(k) will likely be taxed at your ordinary income rate, which might be around 25%. If so, you could see a $250,000 tax hit. In the Roth, you'd get $250,000 more in your pocket.

A huge opportunity approaches
Presto! You now know more about the Roth than many, if not most, Americans. A Fidelity survey recently found that only about 56% of Americans are confident that they understand Roths. Yet many more than that didn't know the various basic rules governing Roths, including the income restrictions that keep many people from qualifying for Roth contributions.

Here's a huge Roth fact that you may need to know, and one that Fidelity found nearly 90% of survey respondents were unaware of: There's a rare window of opportunity approaching. Beginning in 2010, income limits will disappear for Roth conversions. That means you can take various retirement accounts (such as traditional IRAs and 401(k)s) and convert them into Roth IRAs. You may pay some taxes on the conversion, but once the new Roth account exists, its contents will grow tax-free.

Converting won't make sense for everyone. But Fidelity suggests that "if investors have at least 10 years before making withdrawals, anticipate a higher tax rate in retirement, or plan to leave savings to heirs, they should consider a conversion."

Before you make that leap, do your homework. Consulting a reputable, fee-only financial advisor might help. So will these articles. Give them a read; we promise, you won't regret it.

Paying some attention now to your future retirement can pay off in spades. Don't be a needless victim of retirement killers.For clear guidance, try our Rule Your Retirement newsletter free for 30 days. It even offers recommendations of promising stocks and mutual funds.

Longtime Fool contributor Selena Maranjian owns shares of Procter & Gamble and General Electric. Best Buy is a Motley Fool Stock Advisor recommendation and a Motley Fool Inside Value selection. Procter & Gamble is a Motley Fool Income Investor recommendation. The Fool owns shares of Procter & Gamble and Best Buy. Try any of our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.


Read/Post Comments (15) | Recommend This Article (37)

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 09, 2009, at 11:14 AM, KevinNU7 wrote:

    Hello,

    I don't think your analysis holds, or maybe I am just misunderstanding. In your example you say that $10k for Nike would have grown to $209k after 20 years. At a tax rate of 15% this means a total $178k in pocket.

    Assuming that we pay taxes first to avoid taxes on the profits we would NOT have $10k to invest. We would have $10k less the 15% taxes. This would reduce your amount to invest to $8,500. $8,500 at the 2,092% brings you to $178k, which is exactly the same as the Non-Roth option.

    The only play you really have in my opinion is the decision to pay taxes now because you believe the tax rates will be higher in the future.

    Using a scenario where the tax rate is currently 15% but would grow to 20% in the future, you would end up in a scenario where the Non-Roth option would only give you $167k after taxes but the Roth option would still give you $178k.

  • Report this Comment On October 09, 2009, at 11:33 AM, Stocklovr wrote:

    This is a very good article but I never see the following question answered:

    What happens to future contributions after conversion to a Roth. In other words, if you are over the income limit today, you can't add to or create a Roth. If you covert, are the income limits going away and you can continue to add to this account each year like you would a regular IRA?

    Most articles (this included), only mention the possible conversion. I would like to know if the income limits disappear and you can add to the Roth or if it's a one-time conversion but based on income, may not be able to add to each year.

    I'm sure that others would like to know the answer to this too so if anyone knows, please enlighten us.

    - Slvr

  • Report this Comment On October 09, 2009, at 11:42 AM, Stocklovr wrote:

    KevinNU7 : There is another benefit. If you plan to leave any or all of your retirement account to you heirs, the Roth has huge benefits.

    I am not a tax professional but the way I understand it is that your heirs would have to start taking distributions, at some point, from a regular IRA and therefore pay taxes.

    With a Roth, those tax-free gains could be passed from generation to generation - tax free to your heirs. That along with the potential for higher taxes, I think, are the two major benefits. The downside, as you point out, is that you have less to invest or spend today because the Roth is aftertax dollars.

    Please feel free to correct me if this is inaccurate but this is the way I understand it.

    -Slvr

  • Report this Comment On October 10, 2009, at 11:28 AM, thisislabor wrote:

    stocklovr,

    I'm a tax preparer, I feel I can answer a few of your questions. perhaps not all off the top my head at least.

    You can have two IRA accounts that is OK. If you do convert one traditional account to a Roth IRA, it is ok if they do change the income-limitation-on-contributions rules later. if you no longer can contribute to your Roth because you make too much money- you just open up a new traditional IRA and contribute to that one instead up to the income-limitation-on-contributions. and manage now two IRA accounts, one the Roth and one the Traditional.

    (the contributions are limited based on your income)

    Your conversion from traditional to Roth counts as income, but off the top of my head without looking at the forms again I believe not 100% sure, but that income from conversion does not count towards your income towards contributions.

    two types of incomes. make sense?

    There is an income limit on both the Roth and Traditional IRA accounts for contributions.

    These limits change depending on whether or not you AND/OR your spouse have the option to contribute to an employer sponsored retirement plan too.

  • Report this Comment On October 10, 2009, at 11:32 AM, thisislabor wrote:

    *You can have two IRA accounts that is OK. If you do convert one traditional account to a Roth IRA, it is ok if they do change the income-limitation-on-contributions rules later. if you no longer can contribute to your Roth because you make too much money- you just open up a new traditional IRA and contribute to that one instead up to the income-limitation-on-contributions-on-deductions. and manage now two IRA accounts, one the Roth and one the Traditional.* - that is how that paragraph should have read.

    ( I hate retirement plans so rediculously stupid some of the terminology.... )

  • Report this Comment On October 10, 2009, at 11:39 AM, thisislabor wrote:

    I did a really bad job answering your questions. I'm sorry. I need to reread the pub on it. I'll do that this weekend and retry to answer you on sunday or monday.

  • Report this Comment On October 11, 2009, at 4:56 PM, thisislabor wrote:

    http://www.irs.gov/pub/irs-pdf/p590.pdf

    so this is the link I am pulling all my information from to answer your questions.

    (these are questions I got out of what you said, if they are not correct let me know"

    Question: After you convert the account can you still make annual contributions to the new IRA?

    Yes, after you convert your traditional IRA to a Roth IRA, you can still contribute upto 5000$ each year to your Roth account. The contribution amount of 5000$ will probably be increased by 500$ each year. (so up to 5500 in 2009, upto 6000 in 2010, etc.. etc..)

    Questions: Is there an income based contribution limit on an IRA?

    Answer: Yes, at 85k MFJ. 55k for S is the start of the DEDUCTIBLE contribution income limit for Traditional IRA's.

    If you make more than the income limit you can still contribute to your traditional IRA but you can not deduct the contribution.

    Question: Do Roth IRA income limits disappear after conversion?

    Answer: No, they don't. The income limit for a contribution still starts at around 155K for MFJ and 95K for S. (I say around because the limits for income move every single year).

  • Report this Comment On October 11, 2009, at 5:05 PM, thisislabor wrote:

    And as far as what happens after death of the owner of the IRA, I think your spot on.

  • Report this Comment On October 12, 2009, at 10:22 AM, Big50Shooter wrote:

    I set up my first 2 Roth IRA's for my wife and I last year, and while I think it's a good idea to have a Roth, along with a "normal" IRA, my accountant did the math with me last April and showed me that if you are in a higher tax bracket, that the tax discount you get by contributing to a regular IRA with pre-tax $$$ is hard to overcome unless your Roth can yield some rediculously high gains... In other words, take the tax discount now, and invest that money, and you will usually be ahead of what you would have gotten from a Roth funded with post-tax dollars...

    I'm not sure about the inheritance tax issues, but if you really want to shield money for future generations, large life insurance policies work well (and their payouts are also tax free to your kids), and also, if your kids have a trust that is close to the federal limit, establish generation skipping trusts for your kid's kids... These are kinda neat as the funds skip your kid's trust limits and your children can be the trustee of them, and still have access to the funds should they need them....

    But, I'm a shooter, not a tax man, so check with your lawyer... Your mileage may vary... Never eat spinach with a stranger...

    Pat

  • Report this Comment On October 12, 2009, at 11:39 AM, jfenlon wrote:

    Two questions:

    Must you be employed to contribute to a Roth?

    Can you convert a portion of a traditional IRA to a Roth rather than the entrire amount?

    I will be retired in two years (still working at 70 1/2). I will face a large tax bill if I convert 100% next year, even though I can split the cost over 2011 and 2012, because I will still be working then.

  • Report this Comment On October 12, 2009, at 1:23 PM, thisislabor wrote:

    jfenlon.

    No, you don't have to be employed to contribute to your a Roth, any local bank or S&L institution ought to be able to set one up for you. You can also go to pretty much any brokerage house to set one up too.

    Yes, you can convert only a portion if you decide to.

    The portion that you convert will have to be taxed as regular income....

    Big50Shooter,

    Deagle style huh? : )

    Anyways, you can also give 12,000 a year (both you and your spouse) tax free today. (the exact amount may be 12,500 now off top my head dont remember exact number).

    As far as the trusts things go, I will have to say you have hit the extent of my knowledge, I don't know much about trusts.

  • Report this Comment On October 12, 2009, at 1:24 PM, thisislabor wrote:

    jfenlon,

    you do have to have income though equal to the amount you want to contribute though.

  • Report this Comment On October 17, 2009, at 1:33 AM, drborst wrote:

    "Imagine hitting retirement with a $1 million Roth IRA account and a $1 million 401(k)."

    Right now, with 20 years before I retire, I have enough in my 401K to hit a million. I pay AMT and worry a lot about a tax hit.

    Is there any reason I don't change just my contributions to a Roth and skip the conversion tax hit? Is that 'best of both worlds' or more like 'worst of both'?

  • Report this Comment On October 17, 2009, at 12:32 PM, snorthca wrote:

    I recently inherited $50,000 from my father's trust. It is my understanding that this money is tax free. Would I have to pay taxes on it to put it into a Roth account?

  • Report this Comment On December 03, 2009, at 10:13 PM, eps1677 wrote:

    A couple of questions to who may know and care to share about the article above:

    Transferring from a traditional IRA or 401K to a Roth:

    What is the tax that is paid when rolling over? Is it calculated based on your tax rate now, at the time you made the contribution, or something else?

    My wife is no longer working and if the tax is based on your current AGI, she would not have any tax liability to consolidate her accounts to a Roth?

    One more question: Is there anything I need to know pertaining to vested employer contributions in a 401k that would be rolled over to a Roth?

    Thanks,

    eps1677

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Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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