New Roth IRA Edge For The Wealthy
Roth IRAs can be a sweet deal. If you've invested wisely so that you expect your income tax rate to rise in the future, including retirement, a Roth typically hands you more after-tax money than a traditional IRA.
But high-income taxpayers face hurdles with Roths. A key one: You can't make Roth contributions — or deduct traditional IRA contributions — if your income is over certain amounts.
Still, there are legal ways to get around those limits, thanks to a new tax rule. Now, anyone with a traditional IRA can convert that account to a Roth IRA.
You'll have to pay ordinary income tax on any amount you convert that got tax-deferred treatment. But you'll be eligible for Roth IRA benefits, such as completely tax-free withdrawals after five years and after age 59 1/2. And, depending on your future tax rate, you could end up with more after-tax money.
Up to this year, such conversions were available only to those with modified adjusted gross income (MAGI) of $100,000 or less.
Anyone with earned income, and workers' spouses, can make a nondeductible contribution to a traditional IRA. In fact, you now can contribute for 2009 and 2010.
Then you can convert your traditional IRA to a Roth IRA.
You can contribute to a traditional IRA for 2009 up to April 15. You also can contribute to a traditional IRA for 2010, now that it's a new year.
Workers and their spouses can contribute up to $5,000 each year to their IRAs. Those 50 or older can contribute up to $6,000.
So a hypothetical John and Mary Smith, both age 51, could kick in as much as $24,000 by next April 15. That can be put into traditional or Roth IRAs, or a combination.
That's important because of restrictions on who has a legal green light to contribute to a Roth IRA.
Single taxpayers have the OK if their MAGI is $120,000 or less in 2009 or 2010. The MAGI ceiling for couples filing jointly is $176,000 in 2009 and $177,000 this year.
Workers covered by an employer's retirement plan can deduct their contributions to a traditional IRA for 2009 if their MAGI is $65,000 or less (single) or $109,000 (joint).
For 2010, the ceiling for singles goes up to $66,000.
Spouses of covered workers can't deduct traditional IRA contributions if their joint MAGI was over $176,000 last year or is over $177,000 this year.
Legal Loophole
So you are shut out from Roth IRA contributions and from traditional IRA deductions if your income tops the limits described above.
But you can make a nondeductible contribution to a traditional IRA, up to the $5,000 or $6,000 limit for each year, regardless of income.
Then you can convert the balance to a Roth IRA. You'll wind up with the benefits of a Roth IRA.
You can withdraw the money you converted at any time, tax-free. After five years and after age 59 1/2, your investment earnings also qualify for tax-free withdrawals.
And you'll never have to take any required minimum withdrawals from your Roth IRA.
The money can keep growing tax-free, potentially for years or decades.
"Your beneficiaries could wind up with a bigger after-tax windfall than they'd get from inheriting a traditional taxable IRA," said Ed Slott, who publishes the IRA Advisor newsletter. They'd pay no tax on it.
If you make a nondeductible contribution to a traditional IRA and convert to a Roth IRA, you set the stage for tax-free investment earnings, for yourself or your beneficiaries.
Suppose you contribute $12,000 of after-tax dollars to a traditional IRA for 2009 and 2010.
Then this year you convert to a Roth IRA when your account balance is still $12,000. Those are all after-tax dollars so you won't owe any income tax on the conversion.
But suppose you make $12,000 of nondeductible contributions. They grow to $15,000 in your traditional IRA. Can you convert just the $12,000 of after-tax dollars, tax-free?
No. Every Roth IRA conversion is taxed in proportion to the pretax money in all of your traditional IRAs. That's the case even if nondeductible contributions are in just, say, one of several IRAs.
If you have $15,000 in traditional IRAs, including $12,000 of nondeductible contributions, the after-tax money is 80% of the total.
If you convert the $15,000 to a Roth IRA, you'll owe tax on $3,000, 20% of the total.
Figuring Your Tax
Suppose you convert only $12,000 to a Roth IRA and leave $3,000 in the traditional IRA.
You'll have $2,400 of taxable income, 20% of the $12,000.
The same holds if you already have a traditional IRA and make nondeductible contributions. Suppose you have $88,000 in a traditional IRA now. All that money is pretax.
You contribute $12,000 of after-tax money for 2009 and 2010. Now you have a total of $100,000. So 88% of the conversion is taxable.
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