No one likes to pay taxes any sooner than they have to. But if I told you that you could lock in today's relatively low tax rates in advance of what could be a mammoth tax increase coming next year, you'd probably jump at the chance.
That's exactly the opportunity you have by converting your traditional IRA or 401(k) to a Roth IRA. You'll generate a sizable tax bill that you'll owe next year, but in exchange, you'll free yourself from the anxiety over what will happen to tax rates in the future.
The writing's on the wall
Congress was generous enough to extend tax cuts that were slated to expire in 2010 through the end of this year. But come 2013, all bets are off, and the budget proposal from the Obama administration clearly draws battle lines for what could be one of the biggest tax increases in history.
In particular, with the budget as currently proposed, the following higher taxes would take effect next year:
- Ordinary income tax rates on joint filers earning $250,000 or more would rise from 33% and 35% to 36% and 39.6%, respectively.
- Maximum rates on capital gains income would rise from 15% to 20%.
- The preferential rate on dividend income would disappear for high-income taxpayers, leading to an increase from 15% to as much as 39.6%.
On top of that, a surtax enacted by the health-care reform laws will also take effect next January, adding another 3.8% in taxes on investment income for those above the $250,000 threshold. For single filers, the threshold amount in all these cases is $200,000.
Prepay your taxes
By contrast, if you convert to a Roth this year, you'll owe tax based on this year's tax rates. Sure, that means you'll pay your tax earlier than you might otherwise have had to -- decades earlier, in some cases.
But if you think the odds are good that tax rates are heading up for good, then you might reasonably believe that this is your last, best chance to get the most favorable rate you can. After you pay once, you'll never pay taxes again in a Roth.
Maximize your earnings
Tax-free Roths encourage big growth opportunities. So if you convert to a Roth, what should you invest in? A couple of current plays are worth considering:
- If you think natural gas is bottoming, then the right stocks could skyrocket in a gas recovery. On one hand, low-cost provider Ultra Petroleum (NYS: UPL) would enjoy top-rate margins if prices rose. But counterintuitively, it's the higher-cost companies that could see the biggest share gains from a gas price recovery. That bodes well for Chesapeake Energy (NYS: CHK) and Range Resources (NYS: RRC) , which have costs that exceed the industry average.
- Beaten-down financial stocks Bank of America (NYS: BAC) and Citigroup (NYS: C) have languished for years. But they're also most prone to get the biggest bumps from a return to stability in the financial system.
The benefit of these high-risk plays in a newly converted Roth is that if they go well, you get to keep the profits on a tax-free basis. If they go badly, however, you can essentially get a do-over, recharacterizing your Roth. You still suffer the losses, but you undo the tax hit your conversion took. That amounts to a rare heads-you-win, tails-the-IRS-loses situation that you won't want to miss.
Don't wait too long
You have until the end of the year to capitalize on the Roth conversion opportunity. So you may prefer to wait until the future for taxes in 2013 and beyond is more firmly set before you act.
On the other hand, the recharacterization feature means you don't have to wait if you don't want to -- because you can always undo the conversion later if things change between now and 2013. If you have investments you think are likely to take off sooner rather than later, then not having to wait could make a huge difference in how much money you retire with.
Taking opportunities to cut your taxes is just one thing you have to do to retire rich. Another is picking the right investments. Please accept my invitation to read The Motley Fool's latest special report, in which you'll find three attractive stock ideas for those investing for retirement. The report is free -- but don't wait: Click here and read it today.
At the time this article was published Fool contributor Dan Caplinger does whatever it takes to cut his tax bill. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Ultra Petroleum, Citigroup, and Bank of America. Motley Fool newsletter services have recommended buying shares of Ultra Petroleum, Range Resources, and Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you its best every day.
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