Sometimes, opportunity comes buried in jargon that only a tax attorney could love.
The new rules around Roth IRA conversions are an excellent example. I mean, I don't know about you, but terms like "recharacterizations" and "modified adjusted income" work like magic -- to start my eyes glazing over.
For many folks, the rules around IRAs were already arcane enough before the new provisions came along. But these new rules are worth taking a little time to understand, because there is indeed a wealth-making opportunity here.
An opportunity to have much more money when you retire.
I wasn't joking about the "wealth" part
Here's the essence of the new rules, in a plain-English nutshell. As of the beginning of 2010, you can convert your other IRAs to a Roth IRA, regardless of your income. And if you change your mind, you can undo the conversion, and the tax consequences are as if it never happened.
Why is this significant? As you probably know, with a traditional IRA, you contribute pre-tax money, and that money grows without having to pay taxes along the way. But you pay taxes on your withdrawals when you retire.
With the Roth IRA, on the other hand, you contribute after-tax money -- but it (and your capital gains) are tax-free forevermore. A Roth is especially appealing to those who think their income in retirement is going to be high -- but one can only contribute to a Roth now if one's income is below certain limits ($105,000 in 2010, or $167,000 for couples).
Folks who are active, involved investors are often ideal candidates for a Roth -- you'll never pay taxes on your gains! -- except that many have been shut out by those income limits. But with these tax-law changes, you can convert your regular IRA to a Roth.
And that means the big IRA balance you hope to have in retirement will be all yours. See what I mean about making you rich?
Of course, there's a catch -- and a surprise
The "catch" is the obvious one -- you have to turn that pre-tax money in your traditional IRA into after-tax money in your new Roth, and that means sending a big check to the IRS. If you do the conversion in 2010, the IRS will let you split the amount due between your 2011 and 2012 tax returns, to soften the blow -- but in the future, that lump sum will be due with the rest of your taxes on April 15.
The "surprise" is that, if the conversion turns out to have been a bad move, the IRS will let you have a do-over. Called a "recharacterization," this procedure lets you un-convert your IRA, and from the IRS' perspective, it's as if it never happened.
Why would you want to do this? Suppose, back in March, you had chosen to convert your IRA and taken a big position in BP, trading around $55 a share. You'd now be committed to pay taxes on that $55 -- but in the meantime, the Gulf of Mexico disaster happened, and your BP stock is now worth more like $35 a share.
A do-over would look awfully nice in that situation, wouldn't it? It wouldn't restore the value of your stock, of course, but it'll get rid of the tax bill you incurred for converting it.
Putting this to use in the real world
Of course, most people with sizable IRAs have a bunch of different holdings. Some might be higher-risk stocks, some might be bonds or low-drama stocks you're holding for the dividends. Recharacterizing the whole thing after one of your stocks blows up might not be the best plan.
Fortunately, there's a way around that problem. In the new issue of the Fool's Rule Your Retirement newsletter, advisor Robert Brokamp offers a bunch of tips on Roth IRAs, including a simple way to handle that situation: Set up multiple Roth IRAs.
Robert suggests you organize your IRAs around different types of investments. For instance, you might divide your accounts as follows:
- Put your fixed-income investments in one account. Whether you own bond ETFs iShares Barclays Aggregate Bond Index
(NYSE: AGG)and Vanguard Total Bond Market ETF (NYSE: BND), regular bond mutual funds, or individual bonds, keep them all separate from your stock holdings.
- Put your relatively "boring" long-term stock holdings together in a second account. That could include Kimberly-Clark
(NYSE: KMB), Altria (NYSE: MO), or any of a host of other great stocks with rising dividends. It might even make sense to put Apple stock into this category; it's far from boring, and the shares fluctuate, but a huge near-term loss is relatively unlikely.
- Put your high-octane, speculative investments in a third account. For instance, many are using iShares Silver Trust
(NYSE: SLV)to speculate on silver catching up to gold's big run. If you think the market is prone to start falling again, ProShares UltraShort S&P 500 (NYSE: SDS)is a risky but potentially lucrative way to play it.
See what I mean? Of course, I've barely scratched the surface of the possibilities here. If you're interested in going down this road, you should definitely check out Robert's comprehensive coverage of Roth IRA conversions -- including an interview with IRA guru Ed Slott -- in the new issue of Rule Your Retirement.
Rule Your Retirement is a paid service, but you can check out Robert's article -- and lots of other great content -- for free with a no-obligation 30-day trial.
Want some great stock ideas for your new IRA? Dan Caplinger has six stocks that could save your retirement.