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What an incredible tool this is. I am surprised the by the number of families unfamiliar with how a ROTH really works. I am equally as excited by the prospect of what it can do for families.
The magical term that you need to learn is Tax Arbitrage! Why do you need to learn this fantastic term? The clear answer is, “It sounds impressive at dinner parties.” Think of it now, you are dressed to the nines (maybe even the tens) and while discussing the merits of antidisestablishmentarianism, someone mentions how well their portfolio is doing. You, of course, snort derisively and quip, “The real magic is in after tax returns.” You go on to explain that your returns are completely immune to taxes and you have been effecting a customized tax arbitrage strategy. Mouths are agape, champagne glasses are being dropped, and everyone wants to be you friend.
“The magical term that you need to learn is Tax Arbitrage!”
So … what is tax arbitrage? In simple terms it means paying less taxes over time. We use the current tax code with an eye toward the future. If you knew that converting, or contributing, money to a Roth today meant that you would pay less in taxes in the future, would you do it? If you said, “Yes,” you would be practicing tax arbitrage. The problem is that tax planning doesn’t sound NEARLY as fancy as tax arbitrage. Tax planning sounds boring. Tax arbitrage makes you sound like a secret agent.
“Ok Scott, I want to be a secret agent. How does a Roth work?”
When contributing money to a 401k or IRA, you receive a write off up front and defer (i.e. procrastinate) paying taxes. Sometimes this works in your favor. In a Roth, you pay taxes up front and never owe taxes again on that money. Think about it one step further. You can choose if you want to pay taxes on your returns. In an IRA you avoid some up front pain (taxes), but you will eventually have to pay taxes on your contributions and your returns. In a Roth, you pay taxes on your contributions up front, but you will never pay taxes on your returns. A Roth allows you to legally avoid paying taxes on your returns.
“… see if a Roth conversion or contribution is a good option for you.”
You can take your Roth money tax free in the future. You don’t have to take RMDs (required minimum distributions) if you don’t want. You can pass it down to your kids tax free. OH THE WONDERFUL OPTIONS!
However, before we can go down this route, we need to see if a Roth conversion or contribution is a good option for you. You need to look at future expenses and incomes. If we find that using a Roth accounts saves you taxes in the long run, we use it.
Who are some people that I see that commonly benefit from Roth accounts? Families that have a pension that covers most (or all) their expenses will typically experience a benefit. Families who have highly appreciated assets, will typically benefit from this kind of strategy. Families that have huge positions in qualified plans (401k, 403b, IRAs, SEPs, etc) and are going to be killed by their required minimum distributions will often benefit. Families with very low expenses may also benefit from Roth conversions.
Here is your test, which account should you have? Should you have a Roth or an IRA?
The answer for most families is both.
Don’t pay too much in taxes and don’t play chicken with your nest egg!

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