Higher Taxes Won't Hurt These Investments

As if all the troubles investors have suffered through during the bear market weren't enough, higher taxes in the future look more likely than ever. But if you act now, you can essentially lock in today's lower tax rates -- and never have to pay tax on your investment income again.

The recently released federal budget reveals some plans to hike taxes on those in the top two tax brackets in 2011. Tax rates on ordinary income could rise between three and five percentage points, while the maximum rate on capital gains and dividend income would go from 15% to 20%. In addition, high-income earners would lose some of the benefit of several popular tax deductions, including charitable contributions and mortgage interest.

But there's a way you can turn the tables on the IRS. And while many high-income taxpayers haven't been able to take advantage of it in the past, the rules are changing next year -- so get ready.

'Tis the season to save taxes
For years, investors with hefty tax bills have looked longingly at the benefits of Roth IRAs. Granted, being in a high tax bracket means that if you qualify, you can save a lot in taxes by making a deductible contribution to a traditional IRA -- as much as $2,100 under current law, if you're age 50 or over.

However, with a traditional IRA, your retirement nest egg has a perpetual cloud hanging over it -- in the form of the taxes you'll have to pay when you take money out after retirement. Those withdrawals don't even get the benefit of lower tax rates on capital gains and dividend income, meaning you'll pay as much as 35% in tax -- or more, if rates rise in the interim.

That can add up to a lot over time. For instance, here are some examples of the deferred tax liability that would have been generated on dividend income from owning 1,000 shares of these popular income-producing stocks:

Source: DividendInvestor.com. Assumes top 35% tax bracket applies in retirement.

Potentially, you could be accumulating thousands in tax liability each and every year -- something you definitely won't like paying when you're on a fixed income after you retire.

The Roth IRA, on the other hand, blows that cloud away. Since you can't take a tax deduction for a Roth IRA contribution, you essentially lose the up-front tax savings. In exchange, though, you get something potentially much more valuable: tax-free treatment for as long as you or your heirs hold the account.

Roth IRAs are also somewhat more flexible than their traditional counterparts. With regular IRAs, you have to start taking distributions beginning in the year in which you turn 70 1/2. Roth IRAs, however, have no required minimum distributions. So if you don't need the money -- or would prefer to spend it from another source -- you can leave your IRA money untouched, letting it grow tax-free for even longer.

Opening the door
Until now, Roth IRAs have been closed off from high-income taxpayers. But next year, the gates will open as the $100,000 limit on IRA conversions goes away. That will give even high-income taxpayers an opportunity to lock in relatively low tax rates now -- just in time to avoid proposed tax hikes that the administration wants to see take effect in 2011.

Want to know more about getting into a Roth IRA? You'll find some useful information on IRAs of all types here. Also, be sure to check out the online resources from our Rule Your Retirement newsletter service. You'll find tax calculators, guides on the best investments for your IRA, and much more. And if you're not currently a Rule Your Retirement subscriber, there's no better excuse to take advantage of our free 30-day trial offer to see what you'll find.

More on making the most of your retirement:

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• Three myths you shouldn't buy into.