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Save on Taxes with a Roth Conversion Right Now

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AlamyMost workers have a looming tax bill they know nothing about. But even as the big stock market plunge reminds many of the scary bear market of 2008 and 2009, there's a potentially huge silver lining for enterprising investors.

The strategy you should consider involves any traditional IRA or 401(k) accounts that you have. If you take the opportunity to convert your traditional retirement assets to a Roth IRA or 401(k), you'll be able to lock in what may prove to be the lowest possible taxes on your long-term nest egg.

Understanding Roths and Conversions

To understand why you might want to do a Roth conversion, you first have to understand how your regular retirement accounts work. With a traditional IRA or 401(k), you get a tax deduction upfront. Throughout your career, your IRA assets can earn income and capital gains without your having to pay tax. When you retire and start taking money out, though, you'll pay ordinary income tax on your withdrawals.

What a Roth conversion does is to transform your retirement assets into a vehicle that allows tax-free growth throughout your lifetime. When you withdraw money from your Roth, you pay nothing in tax. But there's a price you have to pay when you convert: Whatever the value is that you convert is treated as taxable income on this year's tax return.

In other words, by converting, you're agreeing to pay taxes sooner than later. Why would you want to do that?

A No-Lose Situation

There are several reasons why paying tax now rather than in the future might make sense. For instance, many expect tax rates to rise in the future. By converting to a Roth now, you essentially lock in today's current, relatively low rates for what may be substantial retirement dollars. You may have to be careful not to convert so much that you push yourself into a higher tax bracket, but in the long run, you can end up a winner on the tax front.

But the biggest reason why now may be the best time is because the amount of tax you pay is based on the value of the assets you convert. So with stock prices as low as they've been in a year, your tax bill from converting will be a lot less now than it would have been just a month or two ago.

You might wonder, though -- what happens if the market keeps dropping? The amazing thing about the Roth conversion is that you can undo it. By using what's called a recharacterization, you can essentially reverse the process if your investments fall further -- giving you a chance in the future to do the same thing again at even lower tax cost. If you convert today, you have until mid-October 2012 to see how things work out -- and to get your recharacterization do-over if the Roth doesn't end up making you money.

How to Do It

What you need to do to take advantage of the Roth conversion depends on what type of account you have. If you have an IRA, it's as easy as contacting your broker, fund company, or bank that has the IRA and telling them you'd like to convert to a Roth. You'll have some paperwork to fill out, but other than that, the process should be close to automatic once you get started.

Converting a 401(k) may be trickier. If your employer has a Roth 401(k) option, then it may be fairly simple to convert money into that part of the account. Without that Roth 401(k) choice available, though, you may not be able to convert your 401(k) money until you retire or change jobs.

Check It Out

One last thing: Converting your Roth will boost your taxable income. That can have other consequences, such as taking away certain deductions and credits that you'd otherwise be entitled to. Unless you figure out all the consequences of a conversion -- or have your accountant do so for you -- then you could get a nasty surprise come tax time next year.

Tax strategies like the Roth conversion are more complicated than they ought to be. But what they boil down to is that you can use the recent drop in the market to cut your future tax bill. Paying lower taxes is something that everyone can agree is a good idea.

Motley Fool contributor Dan Caplinger is one of those rare people who don't find talking taxes taxing. You can follow him on Twitter here.


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Gigi Jacobs

I'm sorry total income taxed for income taxes.

August 20 2011 at 6:49 AM Report abuse rate up rate down Reply
Gigi Jacobs

I have a question that I have not been able to find the answer to. I understand the GDP. I know its used to determine the amount of government spending we do in comparison along with other things. What I would like to know is if anyone knows what is the number of the total income lets say for 2009 that was taxable? I realize lots of thing are taxed at different rates. I am just looking for total taxable income for one year and what that's called.

Thank you,
Gigi
Bodybygigi@hotmail.com
310-310-1645

August 20 2011 at 6:48 AM Report abuse rate up rate down Reply
amercit

You could invest in a DEMBA ( Democratic Bank Account ) I hear those are 100% tax exempt.

August 14 2011 at 10:04 PM Report abuse -1 rate up rate down Reply
GMC505

Too bad they don't tell the BUTs to all this in the article. BUT if the IRS doesn't like what you did they will write you 1, 2 years or longer...this is to inform you we didn't like what you did and YOU OWE this amount. The rules change for each person and the game is like gambling in Las Vegas, the HOUSE ie: the IRS usually wins.

August 14 2011 at 9:47 PM Report abuse +2 rate up rate down Reply
1 reply to GMC505's comment
savemycountry911

Just pay your fair taxes, people.

August 14 2011 at 10:07 PM Report abuse rate up rate down Reply
savemycountry911

Too little, too late. We're "strewed" thanks to the Socialist in the White House.

August 14 2011 at 9:25 PM Report abuse -1 rate up rate down Reply
daleazuck

This article is right on.

In addition, for those households with two wage earners lucky enough to maximize their Social Security benefits who additionally chose to delay SS payments until age 70, the same year as RMDs from before-tax accounts, their combined total annual SS benefits would be approximately $65,000, which is just about the full current 15% tax bracket. This means RMDs would be taxed at higher tax brackets than otherwise would be encountered if before-tax to Roth conversions reduced/eliminated before-tax accounts ahead of age 70 and the dreaded RMDs.

Of course, this scenario is today's tax world and tax scenarios will change. But the current tax world is what must be used to prepare for the future. This writer has hit the nail on the head and catching market dips to convert to Roth funds has tremendous benefits for the individual in terms of reducing future taxes. Today's goal for conversions to Roth should be to pay no more than 15% tax on the last dollar converted. In 2013, this goal will/may change, who knows, but make the moves today.

August 14 2011 at 2:08 PM Report abuse +1 rate up rate down Reply
1 reply to daleazuck's comment
Setanta

yeah and like they say today---"keyword"---the keyword IS change as in their bs rules,regulations and taxation---ALL subject to CHANGE and you can be sure its not to benefit YOU.

August 15 2011 at 1:30 AM Report abuse -2 rate up rate down Reply
SAUNDERS

There is something the writer forgot to tell you. If you switch to the Roth or withdraw all (or large amount) of your IRA the author is correct you pay taxes on the withdraw at the much higher Federal Tax level. If the withdraw is sizeable it can through you into the top tax bracket of 38% BUT in addition to that your contribution to Medi Care can increase alos. lots of increase!!!!!!! So before you ever do what is written, get some good advise. Be sure whatever the tax bracket you will move into as a result of the withdraw does not have any other effect and if so how much will that cost you. Don't forget State income taxes either. Word of advise.

August 14 2011 at 11:34 AM Report abuse +2 rate up rate down Reply
Hi Den

The government will eventually find a way to drain you of your savings in a 401k, or Roth IRA's. Congress has already held hearings on confiscating 401k's and annuitizing them, derived from the notion that the average joe has no idea how to invest in those programs. As the government monster continues to grow, so does the danger of something like this happening.

August 13 2011 at 11:01 AM Report abuse +3 rate up rate down Reply
1 reply to Hi Den's comment
savemycountry911

They have to support the illegals.

August 14 2011 at 9:37 PM Report abuse -2 rate up rate down Reply
Deborah

With the Liberals in power they will hunt you down like a rabid dog and steal whatever gains you mke to pay for illegal alienns and cell phones for welfare people. Until they make capital gains tax 0% and revise the tax code you can play all the games you like but they will get it from you in the end. And we call this freedom ? There is little freedom left thanks to the left.

August 13 2011 at 8:14 AM Report abuse -2 rate up rate down Reply