Suze Orman Money Matters

I'll bet that right about now you're focused on all the gifts you want to get for your family and friends. But please don't overlook what I consider the must-have gift for yourself in any season: a non-deductible IRA.

That might not sound as exciting as the latest gaming console, but what if I told you that my gift idea could potentially create a six-figure retirement nest egg that's absolutely tax-free? Not tax-deferred -- tax-free.

A Can't-Miss Opportunity

Now that I have your attention, here's the deal: This past spring, Congress passed a new law that will make it possible for everyone -- regardless of income -- to convert their IRAs into a Roth IRA beginning in 2010.

That's a huge investment opportunity, because money you eventually withdraw from Traditional IRAs is taxed at your income tax rate, while all Roth IRA withdrawals are 100-percent tax-free if you've had the account at least five years and wait until you are 59-1/2 to make withdrawals.

While high income earners (singles or couples making more than $100,000) still won't be able to invest directly in a Roth IRA, this new ability represents a great opportunity.

If you've previously shunned IRAs, the best move you can make between now and 2010 is to invest as much as possible in a Traditional IRA. Then, in just over three years, you'll have a nice sum you can convert to a Roth IRA.

The Rules of the Game

Here's what you need to know about IRAs:

• Everyone can contribute to a Traditional IRA, but not everyone can deduct their contribution.

  In 2007, the maximum annual IRA contribution will be $4,000 ($5,000 if you're at least 50 years old). If you aren't eligible for a retirement plan offered through your job, you're allowed to deduct your IRA contribution regardless of your income. Otherwise, the deduction is allowed only if you're single with income below $62,000 or married and file a joint tax return with an income below $100,000.

  The married limit rises to $103,000 in 2007. (If only one of you has a plan at work, the income limit for IRA deductibility is $166,000.) But here's what many higher-income folks overlook: If your income is above those cutoffs, you can still invest in a Traditional IRA and benefit from the tax-deferred growth of your account.
  

  The only catch is that you can't deduct the contributions that you make to your IRA. That's why this type of IRA is known as a non-deductible IRA. When you reach retirement age and make withdrawals from a non-deductible IRA, you'll owe income tax -- but only on the amount above the contributions that you originally put in.
  

  A non-deductible IRA is simply a Traditional IRA in which you don't get any upfront tax break on your contribution. Thus you don't have to pay taxes on those contributions when you withdraw them.

• Not everyone can contribute to a Roth IRA.

  The rules are different here: Only individuals with incomes below $114,000 and couples filing a joint tax return with an income below $166,000 can invest in a Roth IRA. If your income is above these thresholds, a Roth is out of bounds.

  Up to now, that's meant that high-income earners have been shut out from directly investing in Roths.

• Currently, not everyone can convert a Traditional IRA to a Roth IRA.

  As of right now, you can convert a Traditional IRA to a Roth only if your adjusted gross income is below $100,000. That's the limit whether you're single or married.

A Real-World Scenario

Here's where things get interesting. Come 2010, the $100,000 conversion limit vanishes. Anyone, regardless of income, can convert money in a non-deductible or Traditional IRA into a Roth IRA. No strings attached.

That brings us back to my original point: The best gift for high-income earners is to open a non-deductible IRA, because in 2010 you'll be able to convert the money into a Roth IRA.

Yes, you'll owe taxes on any account gains that have accrued between now and your conversion, but once you get the money into a Roth you have a 100-percent tax-free account.

Let's say you're 35 years old and decide to open up your first Traditional IRA by investing the maximum $4,000 this year, and then another $4,000 in 2007. When the max rises to $5,000 in 2008, you stash that sum away in 2008, 2009, and 2010. That's a total of $23,000.

Let's assume that in 2010 the IRA's total value has risen to $28,000. That's $5,000 in gains over what you originally deposited. If you convert the Traditional non-deductible IRA into a Roth, at that point you'll only owe income tax on the $5,000 in gains your account accrued.

Happy Holidays to You (or Your Heirs)

The new law even makes it easy to handle the conversion tax bill. If you convert in 2010, you can spread your tax bill over two years -- 2011 and 2012. (You can also choose to convert smaller amounts over as many years as you want as a way of minimizing your tax bill in any single year.)

Once you convert the money, that $28,000 grows tax-free. And if for whatever reason in 2016 (five years after your conversion) you happen to need money, you can withdraw any amount from your converted Roth IRA up to the $28,000 without any additional tax or penalty, even though you'd only be 45 old.

But let's assume you won't touch the money. If you convert the $28,000 in 2010 and it keeps growing at an average of 8 percent a year for the next 20 years, you'll have more than $130,000. That's $130,000 that Uncle Sam doesn't get a penny of.

Even better; if you don't need the money in retirement, you can just let it sit untouched for your heirs to eventually inherit. With a Traditional IRA, you must start making withdrawals by age 70-1/2.

Now do you see why I think you can't afford to pass this up? It's a potential six-figure-plus gift to yourself or your heirs.