The stock market is down huge; bonds are blowing up; the economy is broken, and Uncle Sam is spending money faster than a drunken sailor on furlough. Boy what a year it’s turned out to be. You may just want to get this year over, but before the New Year’s ball drops, consider building your tax-free accounts.

Last week, we got an e-mail from one of our readers, Bill. He wanted to know if a Roth Conversion was a good idea for him because he is retired. Bill, it’s a great idea if you are like most of us and believe over the long term the markets will recover and that taxes will probably go up.

Tax-free money is great, and here is how it works: If you meet certain income limitations, generally under $100,000 a year, you can take a portion or all of your current traditional IRA and convert it to a Roth IRA, and your money will grow tax free in the future.

Special note for anyone making more than $100,000, the Tax Increase Prevention and Reconciliation Act of 2005 eliminates the income limit on conversions starting in 2010, so you, too, should plan now. If you do the conversion before the end of the year, you will owe taxes on the amount of money that you convert under the current tax code. But as long as you follow the rules, you will not pay any taxes in the future on your conversion amount or on any profits you make!

So let’s look at an example of how this could work.  Bill is 70 years old and has a traditional IRA worth $200,000. Between his Social Security and pension, he has enough money to fully meets his lifestyle needs. Bill is forced to take required minimum distributions because of his age, even though he doesn’t need the money. He is considering a Roth Conversion to eliminate his required minimum distribution. Even though you don’t have to convert the entire balance, let’s assume Bill converts the entire $200,000 balance to a tax-free Roth IRA.

Assuming a tax rate of 35 percent, Bill would owe $70,000 in taxes. Now, the new Roth IRA has no required minimum distributions, and it grows tax free assuming you leave it there for five years and are older than 59 and a half when you access the funds.

Now let’s assume that Bill doesn’t convert his traditional IRA account to a Roth IRA account. First, let’s take a look at the minimum distributions that Bill will be required to take from his IRA account, assuming the same 8 percent growth rate and a 30-year life expectancy.  The total income tax paid during his lifetime on required minimum distributions, assuming a 28 percent combined tax bracket, would be $180,722.

Then the total income tax paid at death by heirs, assuming a 28 percent combined tax bracket, would be $53,011. Add them together and the total income tax paid on his traditional IRA during his life expectancy and at death $233,733. The total income tax paid on the Roth IRA during Bill’s life and at death was only $70,000. So the total income tax savings is $163,733!

The catch is the government is going to change the tax rules in the future. In fact, the rules could change as early as next year. So you need to plan soon, before the end of the year, and run your own numbers. Bill, thanks for the great question, hope this helps.

For more information, tune in every Saturday at noon on 1230 WCWA and every Sunday at 11 a.m. on 1370 WSPD or visit www.retirementguysradio.com.

This entry was posted on Saturday, November 22nd, 2008 at 7:43 pm and is filed under Retirement Guys.
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