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The Smartest Money Move You'll Ever Make

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Smart investors know that delayed gratification can lead to some amazing results. With one new opportunity that nearly everyone can take advantage of right now, swallowing a bitter pill right now could help make you a millionaire in the long run.

As I wrote about yesterday, Roth IRAs have the capacity to save you thousands in taxes throughout your lifetime. Yet many people with relatively high incomes haven't been able to use Roth IRAs in their financial planning. Now, though, the doors are open for those who want to convert existing retirement accounts to Roth IRAs. And never before have so many people been interested in making the move.

What's all the hubbub?
The big benefit that Roth IRAs give to investors is the ability to enjoy tax-free growth from their investments. As long as your assets stay within your Roth, you can buy and sell without incurring capital gains. Moreover, when you withdraw money from your account after you reach retirement age, then you can do so without paying taxes or penalties. That's an advantage you won't find with traditional IRAs and 401(k) plan accounts.

That's why converting to a Roth is appealing to many. Since regular Roth contributions still have income limits, many can't make them. But if you have a traditional IRA, you can now convert no matter how much money you make. Now, anyone who's ever saved for retirement can enjoy the benefits of a Roth.

Sounds great, right? Hold on a minute, though. Converting isn't free. You have to include the amount you convert on your tax return as taxable income, increasing your current tax bill. If you convert all of your retirement accounts, that could easily create a five- or six-figure tax bill just from the conversion -- tax that you'd have to pay a lot sooner than you would if you just kept your money in a traditional retirement account.

Why convert?
So given the possibility of a huge tax bill, why would anybody ever want to convert to a Roth? Again, it comes back to delayed gratification.

One way or the other, once you have money in a traditional retirement account, you'll have to pay tax on it. The question is whether to pay those taxes now or later. For a couple of reasons, it may make sense to pay them now:

  • Taxes on the rise? From all indications, it appears that the current tax rates still in effect for 2010 may be headed higher in the near future. When tax breaks enacted back in 2001 expire next year, there's a high likelihood they won't come back -- and that will increase taxes greatly on the very high-income taxpayers who now have access to Roth conversions.
  • Boost your retirement account's power. If you can pay the tax from assets outside your IRA, conversion effectively boosts the after-tax value of your retirement assets.

Let's take a closer look at that last point. Say two investors owned the same portfolio of stocks in an IRA 10 years ago, with $10,000 invested in each. One of them converted, while the other didn't. Now, they're both retired and looking to withdraw their money.

Stock

Total Value After 10 Years

Potential After-Tax Value in Traditional IRA

UnitedHealth Group (NYSE: UNH  )

$47,918

$31,147

Nike (NYSE: NKE  )

$31,030

$20,170

General Dynamics (NYSE: GD  )

$30,030

$19,520

3M (NYSE: MMM  )

$22,480

$14,612

Goldman Sachs (NYSE: GS  )

$23,873

$15,518

Abbott Labs (NYSE: ABT  )

$21,741

$14,131

FedEx (NYSE: FDX  )

$20,329

$13,214

Source: Yahoo! Finance. Assumes traditional IRA investor is in 35% tax bracket.

After 10 years, both investors have the same amount in their retirement accounts, but the traditional IRA investor faces a huge tax liability. By paying taxes back in 2000, the Roth investor was essentially able to boost the after-tax value of the Roth portfolio by nearly $70,000 -- the value of the original portfolio. And while the traditional IRA investor could have invested the extra money that the Roth investor paid in taxes, that money would have been subject to ongoing taxation that the Roth investor could ignore.

Weigh your options
There are reasons not to convert as well. If you expect lower tax rates after you retire -- perhaps because your income will be lower, or you'll move to a state with a lower income tax -- then it may pay to wait. In addition, higher taxable income from a Roth conversion can cause you to lose some other tax benefits. Finally, if you can't afford the taxes without tapping the IRA itself, conversion loses much of its power.

Converting isn't an all-or-nothing decision, though. Even if you don't convert all of your traditional retirement accounts, moving a portion into a Roth may make sense.

Whatever you decide, you'll want to take a close look sooner than later. Tomorrow, we'll take a look at why making your conversion decision as soon as possible gives you some added flexibility that could save you even more.

Stay tuned the rest of this week as Dan looks into the benefits of the new Roth conversion. Up tomorrow: Why acting now gives you an opportunity you won't want to miss out on.

Fool contributor Dan Caplinger hasn't done a Roth conversion yet, but it's only a matter of time. He doesn't own shares of the companies mentioned in this article. General Dynamics, 3M, and UnitedHealth Group are Motley Fool Inside Value choices. FedEx and UnitedHealth Group are Motley Fool Stock Advisor recommendations. The Fool owns shares of UnitedHealth Group. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gives you all the smart moves.


Read/Post Comments (7) | Recommend This Article (10)

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 January 05, 2010, at 6:36 PM, IdaAg wrote:

    Wow, if you ignore what you would have to pay in taxes to convert to a Roth and assume you start out with the same amount in your account and then for the IRA subtract taxes in the future you have more money in the Roth! Dan needs to subtract taxes out from the $10,000 to start the Roth, let them both grow and then subtract taxes out at the end for the IRA, then look at the results and it would be a lot closer. He is totally forgetting that what you pay now is an opportunity cost for investment and growth. I don't disagree with the Roth, but these numbers are completely misleading. Finally, many people expect to be in a lower income and thus tax bracket when they retire which would shift towards the IRA being favorable. Just show all the facts!

  • Report this Comment On January 06, 2010, at 12:23 AM, healthpicker wrote:

    I think having a week of pros and cons on this subject is very good.

    People have to look at the math and make their individual plans.

    Financial thinking and planning is good for everyone.

    We have Rothed evrything we can.

    The only thing for sure in the USA (in our planning period) is "death and (increased) taxes" for everyone.

  • Report this Comment On January 06, 2010, at 10:39 AM, oldfart139 wrote:

    Two really important facts missing from this and every other discussion of Roth conversions I have seen here at the Fool are:

    No required minimum distributions, so your money can grow forever.

    If your contributions were with after-tax dollars, they will NOT be taxed at conversion - only the gains will be taxed.

  • Report this Comment On January 06, 2010, at 7:04 PM, pussygato wrote:

    a future congress may change the rules and tax your Roth distributions. You can't trust our politicians.

  • Report this Comment On January 13, 2010, at 6:46 PM, EversoNovice wrote:

    within what kind of retirement window makes sense? i hope to retire in 7-10 years and my wife in 10-15 years. Between us we have about 250k. Anyway to learn how to access this?

  • Report this Comment On March 17, 2010, at 8:51 PM, jm7700229 wrote:

    I'm retired now. I moved $150k to a Roth last year and paid the tax with after tax dollars. The gain in my Roth covered the taxes. That gain would have been taxable (and as ordinary income) in my IRA, but then I'd still have the money I used to pay the taxes.

    Moving a significant amount of money will likely put you into a higher tax bracket. Will that be higher than the coming tax hikes? Who knows. Big Brother giveth and Big Brother taketh away. For instance, I would have been a lot better off putting my savings into a non-IRA account, where dividends and gains would be taxed at preferential rates. Sadly, I didn't know those preferential rates were coming.

    The answer is:

    ...keep scrolling...

    ...keep scrolling...

    there is no answer. Buy a lottery ticket and take your chances.

  • Report this Comment On March 17, 2010, at 8:51 PM, jm7700229 wrote:

    .

Add your comment.

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Dan Caplinger
TMFGalagan

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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