This New Tax Law Could Make You Rich

Some tax law is going to make me rich? What is this stupidity?

It's not stupidity at all. For a long time the Roth IRA rules ---

Aaah. The Roth IRA. I hate that thing. You know that between the royalties on my invention and the dividends on those stocks you told me to buy like Waste Management (NYSE: WM  ) and BP (NYSE: BP  ) , I have too much income to be eligible for a Roth. Everybody keeps telling me how awesome they are but I can't play. Why do you keep bringing it up?

Wait. What invention?

The automatic ginger-mincer. It's huge in Asia.

An automatic ginger-mincer? Is that like a turnip twaddler?

Don't laugh, funny boy, I'm making money just sitting here. And I'm going to be making more, too -- wait until you see our new infomercial.

Uh-huh. Anyway, that's the point I'm trying to make. They got rid of the income limits; not for contributions, but for conversions. As of the beginning of 2010, you can take your other retirement accounts and convert them to a Roth IRA, no matter how much money you make.

Why would I want to do that?

In a traditional IRA, or a 401(k), you put your money in before paying taxes on it. Then, when you're retired and making withdrawals, it's taxed like income. But with a Roth, you put your money in after taxes, and then it grows over time, and all of your withdrawals are tax-free.

It comes down to this -- do you want to pay taxes on the money you have now, or on the money you'll have when you retire?

My stocks have done great in the past year. Apple (Nasdaq: AAPL  ) , Ford (NYSE: F  ) , even General Electric (NYSE: GE  ) , all way, way up. And Apple and Ford look like they've still got room to run.

Uh-huh. One of these days Ford might even be able to pay dividends again.

When I retire 20 or 30 years from now, I'll probably have a lot more money in my retirement accounts than I do now.

Definitely, if you keep picking good stocks.

It'd be really nice not to have to pay taxes on any of that. But that's the catch, right? The Feds never let you get away tax-free. If I convert, I've got to pay all the taxes now, don't I?

Yes, you do. You will have to include the amount you convert as taxable income on your tax return. Although, this year only, you can choose to spread it out on your 2011 and 2012 returns. Even so, depending on how big your retirement accounts are, that could lead to a big, big tax bill.

But here's the thing: Once those taxes are paid, they're paid. The money in your new Roth IRA grows with no taxes on those dividends and capital gains -- not now, not next year, and not when you make withdrawals after your retire.

So I can have a big tax bill today, or a bigger one tomorrow.

Exactly. Say you have $300,000 in an IRA now and you're going to retire in 30 years. If you manage to earn an average 10% a year -- and it's not rocket science to do that in the stock market -- on that $300,000 between now and then, you'll have a little over $5 million at retirement time. Do you want to pay taxes on the $300,000 today, or on the $5 million when you're retired? And just imagine what the tax rate on that $5 million might be by then.

OK, but what if I convert and then the market tanks again? What if that $300,000 turns into $200,000, but I owe taxes on the $300,000?

Then you take a do-over. The tax guys call it a "recharacterization." Anytime between now and next October if you play your cards right, you can un-convert the money you converted, taking account of any earnings or losses while it was in the Roth. So if you convert and your Green Mountain Coffee Roasters (Nasdaq: GMCR  ) stock goes to the moon or Berkshire Hathaway (NYSE: BRK-B  ) suddenly starts paying a dividend and skyrockets, then you just leave it alone and all your gains are tax-free.

But if your stocks tank, you can bring your remaining money back into your regular IRA. To the IRS, it's like it never happened. And then, if you want, you can wait until the next tax year and convert again. So if the market tanks after you convert, you un-convert, wait a bit, and convert again at the lower value.

Why do they let you do this?

I don't know for sure why they changed the rules like this. But if I had to guess ... do you think the government could maybe use some extra tax income right now?

Hmm. OK, what else do I need to know?

Really, it's not that complicated. You should consider the possible downsides of converting, and think about what you should convert and the best things to buy with a Roth, but after that it's up to you and the details of your situation.

And here's one last thought: There's a good chance that federal taxes will be going up before too long. If nothing else, there are some tax cuts that will expire at the end of 2010 that might well not get renewed. If you think a conversion might be for you, you might want to do it sooner rather than later.

Read Rule Your Retirement and become an expert in getting the most out of your retirement savings. Full access is free for 30 days, with no obligation to buy.

Fool contributor John Rosevear owns shares of Apple, Ford, and BP. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers recommendation. Waste Management and Berkshire Hathaway are Motley Fool Inside Value choices. Waste Management is a Motley Fool Income Investor pick. Apple, Berkshire Hathaway, and Ford Motor are Motley Fool Stock Advisor picks. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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  • Report this Comment On January 28, 2010, at 11:54 AM, BrianMav wrote:

    Can't one reduce or avoid paying taxes on IRAs altogether simply by retiring into an area that has a lower tax rate (or perhaps no tax)? I'd hate to pay NY taxes to convert my IRA today when I could retire to FL, VT, NH, etc, and pay only Federal taxes at that time. I've even heard that Puerto Rico residents pay no federal income tax - just a local tax. What about moving out of the country? What does that do to my tax obligations? As I understand it, I can keep a "vacation home" in the US, but still be considered a non-resident as long as I spend more than half the year outside the US.

  • Report this Comment On January 29, 2010, at 6:23 PM, drborst wrote:

    This one is a big deal to me, I hate that the aritcle is written in a silly style. First, answer the question above. I'm interested.

    Second, would I really pay tax on the $5 million? I doubt it, it would be a tax on the amount I take out (or at least on my required distribution which we'll put at %5), which comes out to a tax on $250,000/year.

    Third, if this guy is right and I take out %5/year but grow the principle at 10%/year, I'm still growing it in retirement. What happens when I die with $5.2 million and leave a piece to my kids? (Roth vrs std)?

    Finally, since I'm only going to have 1 million in my 401K when I retire (based on my first 10 years of contributions) and I might be able to get another 2 million from my next 30 years of contributions. How does taxes on $50K sound while I'm getting 100K tax free from the Roth?

    I don't want the hit now (I pay a large state tax and plan to move in retirement) so I stopped my 401K contribution and put the new money into a Roth (and its a Roth 401K, is that different? I make too much for an IRA).

    If you wrote an article I found helpful I'd tolerate the really goofy style.

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