The Beatles’ George Harrison wrote these famous lyrics in “The Taxman” when he realized his earnings were pushing him into the 95% tax bracket in England:

Should 5% appear too small, be thankful I don’t take it all,
‘Cause I’m the taxman, yeah, I’m the taxman.

It may sound far-fetched today, but it was not too long ago, and I believe much higher taxes are coming sooner than any of us wish to believe. During the “Roaring 20’s” taxes were in the 25% range for top earners. Due to lower tax receipts at the onset of the Great Depression, our Congress increased the tax rate in 1932 to 63%, and then steadily pushed it up to 91% by 1963. It was still has high as 70% in 1980, before President Reagan slashed it down to 28%. With today’s top tax rate near 40%, and government budget deficits soaring, we are likely to experience a wave of new taxes and deduction limits.

Over the past 40 years as tax rates have fallen, it has been better to stash money into a retirement account during high tax years, and then withdraw the money at lower tax rates many years later. This 40 year trend is about to swing in the opposite direction, making the misunderstood Roth IRA your best tax friend.

What we don’t Understand, we Avoid
Most articles written about Roth IRAs are filled with complicated tax jargon – sometimes trying to be technically precise, but more often in an attempt to impress the reader. Either way, the information is too complicated and boring, making it virtually useless. While the actual tax rules are complicated, and include many deadlines, amounts, limits, and exceptions, the essence of the rules are very simple. What you need to know is…if, why and how a Roth IRA is to your advantage.

Why Me?
1. Age: The younger you are, the more a Roth is a great retirement tool for you.
2. Wealth: The more likely you are to leave some of your IRA to your heirs, the more a Roth is a great estate planning tool for you and your heirs.

Why Now?
1. Never before available to those earning over $100,000
2. Pay the tax at today’s lower rate
3. Advantageous IRS rules only available for 2010

Why Care?
1. Tax-free withdrawals
2. Lower estate tax
3. More spendable income
4. Lower tax on Social Security
5. No required withdrawals

What’s an IRA?
I imagine you have heard the term, but what is it? It actually stands for Individual Retirement Arrangement, of which there are several types, but the Individual Retirement Account is the most common since its creation in 1975. Money contributed to an IRA is tax deductible, it grows inside the IRA over the years with no taxes due on the increasing value, and then tax is due on each withdrawal. To avoid confusion, many people now use the term “Traditional IRA” to avoid confusion with a Roth IRA. I should note that 401(k), 403(b), SEP, Simple IRA, Profit Sharing Plan, etc., all work similarly to an IRA.

What’s A Roth?
Created in 1997, the Roth IRA works differently than a Traditional IRA when money is contributed or withdrawn. Money contributed to a Roth is not tax deductible, it still grows inside the Roth with no taxes due on the increasing value, but no tax is ever due on withdrawals. In the long-run, Roths are better than IRAs in generating more spendable income, because the taxes are paid early and then never again. This allows the power of compounding returns to work their long-run magic for younger savers and older, wealthier investors leaving money to their younger heirs.

What’s A Conversion?
Roths can be very beneficial, and since so many people already had money in IRAs and the like, the IRS created a process to convert IRAs into Roths if desired. Thus, a Roth Conversion allows you to convert some or all of your IRA into a Roth and pay the tax on the converted amount now, resulting in no future taxes.

A Break for the Wealthy…Really?
Yes, but only because Uncle Sam is desperate! Prior to 2010, the only people who could have a Roth were those making under $100,000 per year. Why? Because the government realized that Roths allow you to pay some tax now, versus lots more tax over the decades ahead, which is better for you and worse for them. Therefore, Congress initially decided to limit the number of people who could have a Roth in order to maximize the amount of taxes paid over the years. However, with our government’s budget out of control, Congress has decided to let you win in the long-run. They are willing to take less of your money if they can have some of it right now. Furthermore, a Roth Conversion makes even more sense with current tax rates being relatively low and likely moving much higher – you will be paying at today’s lower rates, and never again!

Beginning in 2010, two things change. First, everyone can now convert. Second, to sweeten the deal and entice more people to convert in 2010, you can elect to pay the tax due in 2011 and 2012. If you believe your tax rates will be higher in those years, you can still pay all the tax in 2010.

What’s A Recharacterization?
Sorry! I hate to bring up another term (especially this ominous sounding one), but it is important since it provides you an easy out and some great tax and investment planning opportunities. Put simply, a recharacterization reverses a conversion. Thus, if you convert your IRA to a Roth, and later need or want to move some or all of the money back to your IRA, you perform a recharacterization.

One useful strategy for recharacterization is if you convert and the Roth later drops in value. Unfortunately, you paid tax on the higher converted amount. Amazingly, the IRS allows you to pretend that you never converted. By recharacterizing your Roth back to an IRA, you get your taxes back. Then, if desired, you can again convert to a Roth, but at the lower value and pay less tax, keeping the difference. This is just one of many great strategies that use this tax provision to your advantage.

The IRA & Roth pool of required knowledge is deep and wide with new rules being added almost weekly. A great resource is There are so many great planning opportunities, but an advisor must expertly apply the rules to benefit your personal situation.

1. 2010’s new Roth rules provide a unique planning opportunity that should not be ignored.
2. If your retirement account values are lower now than they were last year, then conversion or recharacterization strategies could improve your long-term results.
3. Roth Conversion or Recharacterization strategies involve investment, tax and estate planning considerations. It is important to work with an advisor that understands the interplay of these three areas and who will concisely analyze and simply explain to you how you would benefit.

The bottom line is…IRAs are tax deductible, then merely tax deferred, whereas Roths are not tax deductible, but tax-free for you and your heirs. Roth IRAs are a very powerful retirement and estate planning tool and 2010’s new tax rules are exciting. With increasing income tax rates on the horizon, it’s time to seriously consider a Roth Conversion.

NOTE: This material provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.

This Article appeared in the Jan/Feb 2010 issue of Westlake Malibu Magazine