The Perfectly Legal Way to Pay Zero Tax for Generations

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Most people think of tax shelters as being available only to massive corporations and the ultra-rich. But if you have a job, you have access to a tool that can help you and your family avoid having to pay any taxes on your investment income not just throughout the rest of your life but for your heirs' lifetimes as well. Best of all, it's never been easier to take advantage of these benefits. All it takes is opening a Roth IRA.

How you can become like a big corporation
Back in 2011, the Institute on Taxation & Economic Policy collaborated with the Citizens for Tax Justice to create a list of what it called "Corporate Taxpayers & Corporate Tax Dodgers" covering the preceding three years. Noting factors like accelerated depreciation, deductions for stock options, offshore tax shelters, and industry-specific tax breaks, the report identified many companies that not only avoided paying income tax over that three-year period but also got net refunds back from the U.S. Treasury. Corning (NYSE: GLW  ) and Honeywell (NYSE: HON  ) were among the 30 companies that had negative tax liability from 2008 to 2010, according to the report, while Wells Fargo (NYSE: WFC  ) and AT&T (NYSE: T  ) received the largest amounts in what the report called "tax subsidies" -- representing the difference between what those companies paid in tax versus what they would have paid under the 35% corporate tax rate. Through perfectly legal means, these companies all managed to hold the IRS at bay.

Roth IRAs don't involve any of the strategies that corporations use to their advantage, but they're equally effective. When you open a Roth IRA, you don't get any upfront tax deduction, which is why so many taxpayers never even think to go beyond the traditional IRAs that they're more familiar with. When you're focused on saving taxes now, the traditional IRA delivers a valuable tax deduction you can use on this year's tax return, while the Roth doesn't give you any current benefits at all.

But what you get in return for giving up those upfront benefits is so much more valuable. Throughout your lifetime, the income and gains that your Roth IRA investments generate are tax-free. Once you retire, you can take money out of your Roth IRA without paying any tax as well.

But how can you protect your heirs?
Those benefits are great for retirees, but the even more valuable aspect of Roth IRAs is that you can hold onto them forever. Unlike traditional IRAs, which force you to start taking distributions from your retirement account when you reach age 70 1/2, Roth IRAs have no minimum required distributions at any age. If you don't need the money in your Roth, you can leave it untouched and let those tax-free earnings continue to build.

Even better, you can pass on your Roth IRA to future generations. They will be required to start taking minimum distributions from their inherited accounts. But under the current rules, most heirs can stretch out their withdrawals from inherited Roth IRAs over the course of their expected lifespan, using life expectancy tables to pull out an appropriate percentage of the account balance every year. And best of all, those distributions are free of income tax for your heirs as well, giving you and your family generations of avoiding tax entirely -- all for the cost of forgoing a small upfront tax deduction.

What about income limits?
Some workers aren't allowed to contribute directly to an IRA because their income is above the appropriate Roth IRA income limits. For single filers earning more than $127,000 and joint filers above $188,000, Roth IRA contributions are completely disallowed.

But there's a back-door way into a Roth IRA. If you have a traditional IRA, you can convert all or part of that account to a Roth IRA without worrying about any income limits at all. The catch is that you have to include the amount you convert as taxable income on your current-year tax return, but again, that tax bill is the last one you'll ever have to pay on that money and the income and capital gains it generates over the rest of your life and beyond.

A truly long-term investment
If you've ever thought about leaving a legacy for your children or grandchildren, think carefully about opening a Roth IRA. With decades of potential tax savings ahead, your loved ones will thank you.

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Read/Post Comments (19) | Recommend This Article (45)

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 March 31, 2013, at 11:13 AM, prginww wrote:

    Question: If a person is over 75 years old, is married, and has joint income (unearned-pensions, disability, interest, dividends, capital gains) can the minimum required distribution from a traditional IRA be transferred to a Roth IRA, with the tax on the distribution having been paid from income? Also, if this is allowed, is there a ceiling on the allowed transfer?

  • Report this Comment On March 31, 2013, at 11:50 AM, prginww wrote:

    This makes no sense at all. Under a ROTH you pay taxes on your earned income, then you put it into the yes, you do pay taxes.

  • Report this Comment On March 31, 2013, at 12:09 PM, prginww wrote:

    Mr. Caplinger,

    Isn't the after-tax return from a Roth IRA equal to that from a Traditional IRA, if an individual is in the same tax bracket now as when they retire?

    If so, wouldn't an investor be indifferent as to whether they us a Roth or Traditional IRA?

  • Report this Comment On March 31, 2013, at 12:24 PM, prginww wrote:

    As Petez1 points out, Roth income is most certainly not exempt from taxation. Aside from that, you can't even access the funds until the IRS says so. The age limits they have set are not random. They know many people will die before ever having a chance to cash out, and with the current level of fiscal irresponsibility in Washington you can bet they are already working on ways to steal some of America's private savings [Roth, traditional IRA, etc] back. As with everything sponsored by the US government, tread carefully with Roths.

  • Report this Comment On March 31, 2013, at 1:10 PM, prginww wrote:

    For me, the Roth is a no brainer.

    If I put $10k in a Roth, and grow it to $100k, I've paid taxes on the first $10k, but owe no taxes on the $90k of growth - ever!

    If I put $10k in a traditional IRA, and grow it to $100k, I've saved the taxes on the first $10k, but have to PAY taxes on the $90k of growth - at my marginal rate!

    In addition, much of the gains would have been from capital gains and dividends, which are generally taxes at lower rates than your marginal rate, making it all the worse! No more contributions to anything but the Roth for me!

  • Report this Comment On March 31, 2013, at 1:10 PM, prginww wrote:

    @Petez1, Gunnyphillips:

    Money going into a Roth is money you've already paid tax on, but the Roth income or capital gains on that account is never taxed again (under current rules) and over time that adds up to quite a lot.

    Also, there are no age limits on withdraws of your original contributions, just for Roth income/gains earned.

    @Mr. Caplinger:

    There is more involved than your tax rates on each. If your IRA or Roth outpaces inflation then your after-tax return for Roth is higher even if you are in the same income bracket, but yes the post-tax return could be equal. Even so, a Roth may still be more beneficial, if passed on to an heir that has a higher tax bracket.

    @nancydog: A Roth conversion is treated as a distribution, so yes you can immediately convert your minimum distribution to a Roth up to your Roth contribution limit which is higher at 75. How you pay the tax is irrelevant (it could be from extra money from the distribution)

  • Report this Comment On March 31, 2013, at 1:35 PM, prginww wrote:

    The author only explains half of the "back-door" Roth.

    The way to do this is to make a non-deductible (post-tax) contribution to a Traditional IRA (yes you can do this). The IRA cost-basis after doing this is not zero, the basis increases by what you just contributed since it was post-tax. Then you immediately convert that IRA to a Roth and the conversion is tax-free because you converted post-tax money.

    One Caveat though, you have to be careful if you have other zero basis (pre-tax) trad IRAs because the IRS does not allow you to pick and choose which basis (or lot) you want to use for the money you are converting.

  • Report this Comment On March 31, 2013, at 1:40 PM, prginww wrote:

    To invest in a ROTH IRA requires a large measure of trust in congress. That they won't change the game mid-stream.

    In 1935, FDR promised that Social Security benefits would never be taxable because you paid into the system with after tax dollars (sounds just like a ROTH).

    In 1986, Reagan passed the 1986 Tax Reform act which taxes up to 85% of your social security benefits. (Only if your non-social security income plus 1/2 of your social security is over certain thresholds).

    So what is to prevent congress from doing something like this with the ROTH? Nothing

  • Report this Comment On March 31, 2013, at 1:42 PM, prginww wrote:

    This is all good advice until we get another Obama that makes us eat our IRAs...

    I lived through Carter, Clinton and Obama... each one progressively worse...

    With their re-gressive policies, I could never understand why everyone calls the "Progressives" until I realized, they get Progressively Worse...

    I ate my IRA to survive this Obamanation, and now I owe $1200 to the IRS... which they'll probably never see... I also ate everything except my truck and main tools...

    43 million other Americans could tell the same story...

    My Advice: CASH CASH and More CASH...

    Live below your means and stash it away, you never know how bad the next "Progressive" is going to be

  • Report this Comment On March 31, 2013, at 1:46 PM, prginww wrote:

    "if I put $10k in a Roth, and grow it to $100k, I've paid taxes on the first $10k, but owe no taxes on the $90k of growth - ever!"

    I highly doubt if you put 10k in a Roth IRA and it grows to 100k that you dont pay taxes on that growth - or to some degree dont get taxed. The Government aint going to let you off that easy Really please people put on your thinking caps.

  • Report this Comment On March 31, 2013, at 2:29 PM, prginww wrote:

    Roth IRAs are great if you are rich and have plenty of surplus funds to put into one. However most people do not have that much surplus funds, in fact most people have hard time just funding a 401K fully and an IRA at the same time.

    For most people funding a 401K fully is a chore. Most 401K have an employer contribution but only if you put in matching funds. This employer contribution makes up for being in the 401K instead of a Roth IRA. For instance if you were to put $10k in a 401K and your employer gives a $5k match, you now have $15k in the account. You would also get a tax deduction of $10K from your income and lets say it is worth $3k. So effectively you have put $7k into the 401K and it has $15k. If you never put another penny in the 401K and it earns 5% for 40 years, the 401K will be worth about $106k. The Roth would have cost $10K plus the income tax of let us say $5k. Now after 40 years, the Roth would be worth about $70k. Thus you would have an extra $36k in the 401K.

    It is up to ever individual to decide if the Roth $70K account is better than the $106K in the 401K. For most people the 401K would be better, in my opinion.

  • Report this Comment On March 31, 2013, at 2:57 PM, prginww wrote:

    And who believes the government will not change the tax laws in the future if middle class people start avoiding taxes. They shoulder the tax burden for everyone else. If they should manage to dodge taxes, someone else would have to pay more. Who owns Congress, not the middle class but the rich and powerful.

  • Report this Comment On March 31, 2013, at 3:19 PM, prginww wrote:

    Of course once we corrupt the language and words like taxes become objectionable, the ruling class changes the LANGUAGE.

    The grand theft of the millennium is now called quantitative easing and Ali Baba changed his name to Ben Bernake. How much "tax free" Roth IRA would be worth to you after Ben is done with you?

  • Report this Comment On March 31, 2013, at 5:02 PM, prginww wrote:

    The Roth is a double whammy: deferred spending (if ever) AND tax benefit. Not happening in my household.

    The Roth works if is my only choice.

  • Report this Comment On March 31, 2013, at 6:55 PM, prginww wrote:

    There is a lot of calculation that goes into whether a Roth or traditional is better. However the first question that needs to be addressed is whether the retiree will need the money

  • Report this Comment On March 31, 2013, at 11:37 PM, prginww wrote:

    nancydog: No, you can only contribute to your IRA (does not matter what type) if you have earned income!

  • Report this Comment On March 31, 2013, at 11:56 PM, prginww wrote:

    luckyagain: You're right!

    You should always contribute to your 401 k plan first, if your employer contribute to your plan, because it is free money.

    BUT only up to the limit of the ER's contribution.

    After that you should open up your Roth IRA, contribute to the possible maximum.

    The reason is that more income you have during your retirement years the more your SS check and other income will get taxed.

    Also if you think you'll be a higher tax bracket at your retirement age, first contribute to the 401 k plan until the ER's match, after that you should switch to contribute to the Roth IRA.

  • Report this Comment On April 05, 2013, at 12:03 PM, prginww wrote:

    Cap linger is on target here, absolutely. And the advice about "back door" IRA conversion is mostly correct -- BUT if you are over 71 1/2 you can only " convert" IRA withdrawals in excess of four RMD for the year.

    The back- door conversion is the Bush-era Congress' greatest gift to the wealthy. If you readers were smart, you'd take advantage of it for yourselves too. Most of you seem to be quite bad at the math-- incorrect assumptions and incorrect setting-up of equations. Those who are better at math and logic will make out like bandits at your expense(legally, of course). I will have broken even on my conversion taxes (I converted in 2010) by 2019 and after that everything I earn inside that Roth is gravy-- completely and forever tax-free gravy. No congressional action will ever reverse this law because it benefits the top 1% more than anyone else. But you'd be fools to not take advantage of the law for yourselves.

  • Report this Comment On April 05, 2013, at 12:08 PM, prginww wrote:

    Correction: Your RMD (not "four"). Sorry about that. And please dele the gap in the author' name.

    Typing is not as easy with one finger on an iPod as with tan on a keyboard.

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