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You've Got 4 Days Left to Do This

With a short work week before New Year's, you'll probably be busy getting ready for another three-day weekend. But before you say goodbye to 2011, you need to consider making a last-minute move that could save you thousands in taxes over the long haul.

I know -- it's pretty early for most people to be thinking about their taxes. After all, you've got until mid-April before you have to file a tax return, and you won't even start getting the documents you need to prepare your return until the middle of January. But that's no excuse not to start doing some tax planning. And with the strategy I'm about to describe, if you don't get it done by Saturday, you'll miss what may prove to be your best chance to use it.

It's all about retirement
Tax planning and saving for retirement go hand in hand. That's because you have several useful tools at your disposal to help you save taxes while boosting your retirement savings at the same time. Through 401(k) plans at work, millions of workers contribute money toward their retirement with every paycheck, with some being fortunate enough to get their employers to match part or all of their contributions. In addition, anyone has the ability to save additional money in a personal IRA.

But one aspect that fewer people ever consider is whether to use a regular IRA or a Roth IRA for their retirement savings. Regular retirement accounts give you an up-front tax deduction. But for long-term investors, Roth IRAs give you something that may prove more valuable: tax-free income that lasts not only while you keep your money inside your IRA but also when you take it out. That's an advantage no regular IRA provides.

Still, until a couple of years ago, many taxpayers were locked out of Roth IRAs by income limitations. Starting in 2010, the IRS allowed you to convert existing regular IRAs and 401(k) accounts into Roth IRAs.

The paradox of Roth conversions
The reason so few people convert to a Roth is that it creates a higher tax bill now. You have to include the amount you convert as taxable income, which boosts your taxes.

So why would you ever want to convert? One reason is that lately, many taxpayers have suffered through tough times, seeing their income fall during the recession. As a result, you may be in a lower tax bracket than normal. If that's the case, then taking advantage of temporarily low tax rates to convert part of your IRAs to Roths essentially locks in those low rates forever.

Another reason has to do with the way Roth conversions let you get a free do-over if things don't work out. Basically, you have the right to undo your Roth conversion anytime between now and Oct. 15. So if your investments do well, you get to keep the tax-free gains in your Roth; but if they go down, you can recharacterize your conversion and put the remaining money back in your old IRA -- undoing the tax impact of converting.

What that allows you to do is to take a flyer on some high-risk bets. Here are just a few ideas:

  • Gold prices have slumped from their summer highs, and small miners like Brigus Gold (AMEX: BRD  ) , Primero Mining (NYSE: PPP  ) , and Silvercorp Metals (NYSE: SVM  ) have all seen pretty sizable declines. But if you think metals are poised for a comeback in 2012, getting money into a Roth to invest in them could produce even better after-tax gains.
  • Several promising biotechs, such as Momenta Pharmaceuticals (Nasdaq: MNTA  ) and Arena Pharmaceuticals (Nasdaq: ARNA  ) , have made impressive moves in the past few months. Whether they continue to post gains or flare out like competitor Avanir Pharmaceuticals (Nasdaq: AVNR  ) has done is an open question. But with a Roth conversion, you can benefit either way.

That's not to say that you can't use a Roth for a basic investment as simple as SPDR S&P 500 (NYSE: SPY  ) if you want. But the recharacterization trick opens up some interesting strategies -- if you're willing to dig into them further.

Take a look today
Roth conversions will still be available next year, but if you see your income going up, then you may pay more in taxes if you wait. So don't let 2011 end without at least taking a look at your tax situation. Doing a Roth conversion might be the best move you could possibly make.

But a Roth is just one piece of putting together your overall retirement puzzle. Our latest special free report reveals the shocking can't-miss truth about your retirement -- and what you can do to address it. Grab a copy today and find out everything you need to know.

Fool contributor Dan Caplinger thinks he's ready for 2012. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Primero Mining and Momenta Pharmaceuticals and has sold shares of SPDR S&P 500 short. Motley Fool newsletter services have recommended buying shares of Momenta Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't drop the ball on you.


Read/Post Comments (6) | 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 December 27, 2011, at 11:57 AM, kurtdabear wrote:

    The Roth IRA is designed for folks who believe that two birds in the bush are better than one in the hand. They're willing to pay big taxes now in exchange for the government's promise that they'll let you off the hook later. I prefer the traditional IRA--you get your part of the bargain up front, then when the government goes back on its word when you're ready to retire, you'll still be money ahead.

    And for those who think our government doesn't go back on its promises, ask people who had originally planned to retire at 65 on full Social Security why they now have to work to age 67 to get it, or ask someone who was going to take early retirement with 80% SS payments, why he's getting 75%.

    Also keep in mind that the federal income tax was passed with the promise that it was a rich man's tax that would never apply to the common working man. Of course, if that were true, we wouldn't be having this discussion, would we?

  • Report this Comment On December 27, 2011, at 4:45 PM, jefferiessucks wrote:

    How's Avanir a competitor of Momenta and Arena !!

  • Report this Comment On December 27, 2011, at 6:57 PM, TempoAllegro wrote:

    Kurtabear:

    Hmm...as I understand it, the Roth allows you to have dividends growing inside the account tax free. That is one heck of a difference.

    I think it would be a better choice for many people.

    Now, about your logic on the government going back on promises - if you think that is true, then getting it up front does not matter, does it? Because when the government goes back on its word later, as you suggest, it could do so in such a big way that all of your planning is meaningless.

    I believe our government is so paralyzed by the fear of voter backlash about the idea of going back on retirement promises at the moment that it cannot do what is obviously the best move for the country - a re-doing of entitlements, or at least having a frank discussion of it for starters.

  • Report this Comment On December 27, 2011, at 8:07 PM, clbjblk wrote:

    Watch out for fees you never see and even if you could see them you could not stop them,get into something you can pick and change not the fee takers make them buy there own coffee,you have many avenues learn how to use them before it is to late which is what they want you to do,some people just like to watch and some adjust the choice is yours,Happy Hunting!

  • Report this Comment On December 27, 2011, at 8:10 PM, burningdaylight2 wrote:

    If I was going to take a flyer on a small gold miner I would chose FAU.V. Why Brigus?

  • Report this Comment On January 11, 2012, at 7:07 PM, thidmark wrote:

    Any changes to the Roth IRA would be grandfathered in, otherwise there would be blood in the streets.

    Surely you don't think people are going to just take that lying down.

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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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