Nobody likes to pay taxes. Luckily, Congress has given you a way to avoid paying taxes for the rest of your life -- and it's perfectly legal.
Before you decide that a lifetime ticket to tax-free profits is too good to be true, let me point out one thing: There is a catch. Yet even though you have to give up something now in order to gain access to this completely legitimate tax-avoidance mechanism, the payoff down the road could make what you pay now look inconsequential by comparison. Let's take a closer look at this strategy to see how it can work for you.
Say sayonara to the IRS
In order to give you the latest information on this money-saving financial planning technique, I turned to the experts at the Fool's Motley Fool ONE Tax Center. Providing your email address will get you a free copy of our recently released guide on cutting your taxes in 2013 and beyond, letting you read for yourself about how Roth accounts can be your best defense against the IRS and the changing whims of lawmakers and the tax code.
Roth accounts come in two flavors, one for IRA investors and the other for workers who have Roth options in their 401(k) plans. But both Roth accounts share one key benefit in common: Once you contribute to a Roth, as long as you meet its guidelines, the income that you generate inside the Roth is entirely free of tax. Even when you withdraw money from your Roth account after you retire, you still don't have to pay tax on the proceeds -- and if your heirs are fortunate enough to receive inherited Roth proceeds, they won't have to pay taxes either when they're required to make withdrawals.
So why don't more people take advantage of Roth accounts? One reason is that contribution limits are relatively low -- $5,500 this year for a Roth IRA, with an extra $1,000 if you're 50 or older. Roth 401(k) accounts have higher limits of $17,500 for everyone plus $5,500 for those age 50 or over, but Roth 401(k)s are relatively new, and so not every employee has access to such an account even if their employer offers a regular 401(k).
But the main reason why Roth accounts haven't taken off is that you have to give up something when you choose a Roth. Regular traditional IRAs and 401(k)s give you a tax break now on your contributions, letting you reduce your taxable income by whatever you put into your retirement account. By using a Roth instead, you forego those benefits, which can cost you thousands more in current-year taxes.
Moreover, there are income limits that prevent many high income people from making Roth contributions. Yet that hasn't stopped several smart entrepreneurs from taking full advantage of Roth IRAs to produce profits of millions of dollars. Consider:
- In 2001, PayPal CEO Peter Thiel bought 1.7 million shares of his company's stock for $0.30 per share. When eBay (EBAY +2.36%) bought PayPal the next year for $19 per share, Thiel stood to gain more than $30 million -- all tax-free, since it was in a Roth. Moreover, according to numerous reports, Thiel also invested in Facebook (FB +2.31%) through his Roth, potentially multiplying his previous profits as that stock soared prior to its initial public offering.
- More recently, PayPal co-founder Max Levchin used the same technique to buy shares of social-media company Yelp (YELP 1.00%), resulting in a projected $100 million profit when the company came public in early 2012.
How did they do it? Roth conversions allowed many investors to take existing money in regular IRAs and open new Roth accounts with the proceeds. Income limits applied to conversions as well, meaning that these entrepreneurs probably had to take advantage of low-income years to do conversions. But in 2010, those limits went away, giving access to everyone regardless of income.
Again, converting to a Roth isn't free; you have to pay tax on the amount you converted. But after that upfront pain, your profits for life are nothing but gain -- and your savings in retirement and beyond can be astronomical.
