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?
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.