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High-income taxpayers can now convert traditional IRAs, which allow contributions to be deducted from taxes but incur taxes on distributions, into Roth IRAs, where the contributions are taxed but the distributions are tax-free. The conversion triggers a one-time tax bill based on the value of the newly converted Roth IRA. As one might expect, tax experts are recommending that high-net-worth individuals convert their traditional IRAs to Roth IRAs before 2013, when ordinary income rates are likely to go up.
1. Let's say an investor has one traditional IRA with a value of $4 million.
2. The traditional IRA is split up into four traditional IRAs, each worth $1 million.
3. The investor converts all four to Roth IRAs at the beginning of the year.
4. The IRS effectively allows taxpayers to undo the conversion for up to 21 months. So in 21 months the investor looks at the performance of the IRAs. Say two of them go up from $1 million to $2 million and two drop from $1 million to zero. Because the IRAs were split into four, the investor can change her mind on the two that went down and revert those back to traditional IRAs. Thus, she owes taxes on only the two contributions that went up in value, and nothing on the two that went down, cutting her tax bill in half. This lops 21 months of risk off the bet that paying taxes now will be paid off with tax-free appreciation later.
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