Monday, September 14, 2009

Make Thousands of Dollars by Converting an IRA While Traveling

If you plan (like me) to take significant time off of work for a long-term trip or you've been laid off for a significant amount of time or you're going to join Peace Corps, you can make thousands of dollars by converting an IRA when you're not generating income.


Don't know much about IRAs? Read here: All about IRAs

What I'm going to walk you through is slightly complex and would leave a lot of people shaking their heads, but since I'm actually doing it, I can assure you that it works.

1.Open a traditional IRA. If you already have one, this is going to benefit you beautifully.

2.Contribute as much as you can each year up to the legal limit of $5,000.  This will let you save a thousand dollars or more in taxes each year.

3.After a few years, take a year off to travel (using those tax savings to help pay your travel costs, of course) and convert your traditional IRA into a Roth IRA during the tax year that you are traveling.

4.After five years, take out the money tax and penalty free.

5.Need the money sooner? You can take it out penalty free if you A) buy a first home, B) pay un-reimbursed medical expenses, or C) become disabled (try not to do that).

EXAMPLE:

Bob already has $5,000 in a traditional IRA and will contribute $5,000 a year for 2009 and 2010. Since he's in a 25% tax bracket, every $5,000 that he puts in the IRA is an EXTRA $1,250 in his pocket because he's not paying that in taxes to the government.  As of 2010, Bob would have $3,750 more in his pocket to put towards travel than if he had not contributed to his IRA.

Now let's say it's 2011. Bob is chilling on a beach in Thailand after having emailed his mom and asking him to convert his IRA.  Since he gave his mom power of attorney before leaving on his trip, she is able to convert his traditional IRA into a Roth IRA.  Because Bob has been traveling for the year and has only been making a little money from passive income (more on that in future posts), his taxes are pretty much limited to the IRA he has just converted.  Let's say it's $15,000. 

The marginal tax rate for a single filer is 10% of the money between $0 and $8,350 and 15% of the money between $8,350 and $33,950. With basic deductions, Bob's taxes are $165. Already he's saved $3,585, but since Bob also take deductions for his travel-based business (more on that in future posts), Bob just gets to keep the full $3,750.

After five years, Bob can take out that $15,000 penalty and tax free, or can let it grow as long as he wants.  Even if he grew that money to $80,000 over 30 years, he won't even pay taxes on the $80,000.

And that is sweet.

2 comments:

  1. Daniel,

    Granted, my focus in my profession as a CPA is in audit, not tax, but I find a few errors in your logic (unless I'm missing something)

    1) When you convert from a traditional IRA to a Roth, you pay taxes on the full amount you convert. So not only did you just lose all the tax money you saved, but you'll pay taxes on the profit you made since you started your traditional IRA.

    2) You can take your money out if it's been in for five years AND you're over 59 1/2. Otherwise, you need one of the exceptions noted above.

    Unless there is some loophole I don't know about.

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  2. Daniel Reynolds RiveiroSeptember 21, 2009 at 5:02 PM

    Response from Daniel:

    1) Yes, you pay taxes on the full amount you convert, but if you read what I said, you're paying taxes in a year you're making no other income (since you're on the road) so your taxes are minimal to non-existant, definitely massively less than the tax savings you had in years you had full income.

    2) On a Roth IRA conversion, you can take out the direct contribution (the money you converted out of the traditional IRA, but NOT any earnings you have accumulated from the contribution in those five years--i.e. stock profits, etc.) after five years penalty free. As far as the government is concerned, you paid taxes on that money and it is yours. Any earnings in that time, though, are subject to tax and penalty if you take them out before 59 1/2.

    Hope this clears up the confusion.

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