The Roth IRA

You really have to give kudos to the government on this one. The Roth is working out pretty well so far (for them).

1. Prepay taxes on the gains as money moves from the traditional IRA into a Roth IRA.

2. Watch all gains vanish as the market crashes twice in the same decade.

3. The government still keeps the real prepaid taxes on those illusionary gains though. Perhaps keeps isn't quite the right word. I really mean to say that the government spent that incoming money as quickly as was humanly possible along with money it also borrows from our grandchildren and/or China. Wars and bailouts aren't cheap.

4. Brace for severe recession and/or depression. One reason to brace is that the government no longer has nearly as much prepaid taxes coming to them. How many people are prepaying taxes on stock market gains these days?

5. Lose banking job, lose construction job, lose low-tech manufacturing job, lose high-tech manufacturing job, and/or lose retail sales job. Take your pick.

6. Enter retirement. Sell underwater home. Live in a cardboard box. Withdraw a paltry tax-free sum from what's left of the Roth IRA each year. Of course, it probably wouldn't have been taxed much anyway. It isn't like cardboard box dwellers are in a high tax bracket.

Unhappy with your Roth? Just say never mind

You converted, only to see the stock market tank. Let's say you switched a $150,000 IRA to a Roth IRA in 2008 but the collapse in stock prices has since knocked the Roth's value down to $100,000. Because the tax is based on the IRA's value at the time of the conversion, you're facing a tax bill of $42,000 this April (assuming a 28% tax bracket).

By recharacterizing, you can shift the $100,000 back to a traditional IRA. If your IRA is still worth $100,000 when you convert again, you'll owe $28,000 in taxes, saving yourself a tidy 14 grand.

Just one catch.

You can recharacterize a conversion anytime up to the income tax filing deadline for the tax year of your conversion, including extensions. So if you converted in 2008, you can undo it as late as Oct. 15, 2009.

That really doesn't help those who converted their Nasdaq holdings in December of 1997 (or worse, those who converted in 2000). 1997 was the year the Roth IRA was introduced. The Nasdaq closed the year at 1,570.35. It now stands at 1,477.29.

For what it is worth, I never did convert. I pay my taxes on time but I've never really felt the need to prepay taxes early.

I'm sort of a worst-case planning guy though, as is probably fairly obvious by now. If I was best-case planning guy, I would have come up with a different name for my blog. Paradise of Prosperity?

Worst-case means I'll be broke later in life. Broke people tend to be in a lower tax bracket. It therefore wouldn't make much sense for me to prepay taxes when I am fairly well off just to avoid paying taxes when I become broke.

As a side note, the government is doing a fantastic job heading me down my worst-case retirement plan. The ultimate in timing would be "dying" just as I turn "dead" broke of course, thereby allowing me to maximize every last penny of savings. So far, so good! There is some risk the government will exceed even my own worst-case expectations though. As I have said in the past, the Illusion of Prosperity blog has been consistently too optimistic. I really would not want to hasten my own death just to keep the nest egg depletion rate properly balanced, lol. Nervous gallows humor for the win. Sigh.

It might seem like I am a pessimist to plan for worst-case. Oh contraire! When I plan for worst-case, everything becomes a pleasant surprise. That's a happy thing. Imagine opening a power bill expecting to see a huge number only to see a number slightly less huge? Euphoria. Well, you get the idea anyway.

If I do somehow find myself in a higher tax bracket later on in life because my investments have done so well, then I will have very little reason to complain. I put the odds of this miracle at somewhat less than 100% though. I am worst-case planning guy after all and I generally think of miracles as being somewhat rare.