Roth Conversion Strategy For Those With Higher Incomes

Income Limitation for Roth IRA Conversions

 

For years before 2010, you aren't allowed to convert a traditional IRA to a Roth if your modified adjusted gross income is above $100,000. The same $100,000 limit applies to the overall income of couples filing jointly as singles (something of a marriage penalty), and individuals who are married filing separately aren't allowed to do a Roth conversion at all. The Tax Increase Prevention and Reconciliation Act, which became law in May 2006, eliminates this limitation beginning in 2010. If you have a traditional IRA, you'll be allowed to convert it to a Roth IRA without regard to how much income you have and without regard to your filing status.

    The law includes a special rule for conversions that occur in 2010. For that year only, unless you elect otherwise, income from a conversion will not be reported in 2010, but instead will be reported in two equal installments in 2011 and 2012. The income will be accelerated, however, to the extent you take withdrawals before 2012.

 

Implications. This change in the law has some interesting implications. Consider an individual with annual income of $200,000. This person can't make a regular contribution to a Roth IRA — her income is too high — but she'll be able to contribute to a traditional IRA and then convert to a Roth. As the law is written, there doesn't appear to be any obstacle to doing this annually, effectively skirting the income limitation on regular contributions.

    Taking the idea a step further, some advisors recommend that people in this situation make nondeductible contributions to traditional IRAs now, in years 2006 through 2009, getting a jump start on the process. The entire amount built up prior to 2010 will be available for conversion in that year.

    In either case, you should bear in mind that the income component when you convert to a Roth is determined relative to the total value of all your traditional IRAs. For example, if you happen to have a traditional IRA with $96,000 of money from a 401k rollover (zero basis) and you make a $4,000 nondeductible contribution to a new IRA, thinking you can convert the new $4,000 IRA to a Roth at little or no cost, you'll be wrong. You have to add the two IRAs together to determine the taxable amount, and in this case your conversion would be 96% taxable.

 

Roth Conversion Strategy For Those With Higher Incomes

 

 

 

As of right now, those who file jointly, with Modified Adjusted Gross Incomes of over $160,000 ($110,000 for single filers) cannot contribute to a Roth IRA. They may still contribute to a non-deductible traditional IRA. However, the problem with this is that there’s no tax benefit upfront and the withdrawals will be taxed at retirement.

 

In a few years there will be a way around all this! Here’s how:

 

According to the Tax Increase Prevention and Reconciliation Act of 2005 (here’s a link to a Wikipedia entry on the act) that was signed into law earlier this year, beginning in 2010 conversions to Roth IRAs will be allowed by anyone, regardless of income. As of right now, conversions are only available to those with Modified Adjusted Gross Incomes of less than $100,000. So, until then, a person could contribute to a non-deductible traditional IRA for 2006 - 2009 and then convert that IRA to a Roth IRA in 2010 and pay the income tax on the conversion in 2011 and 2012.

 

Keep in mind that those who do the conversion will have to pay ordinary taxes on everything but your original contributions (known as basis). So, if a person contributes $4,000 per year to a non-deductible traditional IRA for years 2006 - 2009, their basis is $16,000. If the account is worth $25,000 in 2010 when they convert it to a Roth IRA, they will have to pay ordinary income taxes on $9,000 ($25,000 - $16,000 = $9,000). But, the taxes on that $9,000 can be spread out over two years (2011 and 2012), which will add $4,500 to income over those two years.

 

Who would want to do such a thing?

 

Young high-income earners who have a long time until retirement.

Those who like the the flexibility of the Roth IRA. For instance, with a Roth IRA there is NEVER a required minimum distribution unless the Roth is inherited. Also, Roth IRA withdrawals DO NOT count when figuring taxation on Social Security benefits during retirement.

Those who think they will be in a higher tax bracket during retirement.

 

 

The Roth IRA Changes in a Nutshell

 

For tax years after 2009, the Tax Reconciliation Act permits all taxpayers to make Roth IRA conversions, regardless of income level. If you make the Roth IRA conversion in 2010 you will be given the option to pay all the taxes on the conversion with your 2010 return, or with the returns for the two subsequent years by claiming the conversion income on the 2011 and 2012 returns.

 

What Happens When You Make a Roth IRA Conversion?

 

When you make a Roth IRA conversion, you pay income tax on the amount you choose to convert. While my standard advice “to pay taxes later” still represents my strongest recommendation for successful long-term planning, I have always made a “philosophical exception” for Roth IRAs. With respect to Roth IRA conversions, the better advice for many individuals is pay taxes now. While each case will benefit from an individualized analysis on the merits of the conversion, the critical feature of the Roth is that, once the initial taxes are paid on the conversion, income taxes will never be due on the growth, capital gains, dividends, interest, etc. This will be particularly advantageous to high-income taxpayers.