If you haven’t been eligible for a tax deduction on contributions, you probably haven’t been keen on putting money into a traditional IRA. But it might make sense to rethink that view.
By funding a traditional IRA and then quickly converting to a Roth IRA, you could sidestep rules that otherwise might prevent you from having a Roth, which shelters investment gains from tax.
Starting in 2010, anyone can convert a traditional IRA into a Roth. Previously, only investors with incomes of $100,000 or less could do so.
A quirk in the rules makes the conversion process especially appealing to investors who satisfy three criteria:
- They do not qualify for tax deductions on traditional IRAs.
- They do not already have a lot of money in traditional IRAs.
- They exceed the income limits for opening Roth IRAs.
To make the situation clear, let’s go step by step.
These allow investors to put money aside for retirement, paying no tax on investment gains until money is withdrawn. Investors who don’t have pension plans at work and have incomes below certain levels can deduct contributions from their taxable incomes. A $5,000 contribution would reduce the investor’s federal income tax by $1,250, assuming a 25% tax bracket. The Roth IRA Conversion Calculator can show whether conversion would pay.
Investors who don’t qualify for deductions can make non-deductible contributions, regardless of how much they earn. Many people, however, feel that a traditional IRA is not worth having without the up-front deduction on contributions. These tables from T. Rowe Price (Stock Quote: TROW) show who qualifies for deductions.
These do not offer any deduction on contributions but are attractive because all qualified withdrawals, including contributions and investment gains, are tax free. However, people with incomes above certain limits cannot open Roths.
Starting in 2010, anyone, regardless of income, can convert a traditional IRA into a Roth. However, tax must be paid on investment gains and deductible contributions. If one had a $50,000 IRA composed of $10,000 in tax-deductible contributions, $5,000 in non-deductible contributions and $35,000 in investment gains, tax would be due on $45,000. Only the $5,000 in non-deductible contributions would be exempt, since that money had already been taxed.
To calculate the tax, all of the investor’s traditional IRAs are lumped together to determine the portion of taxable and non-taxable funds. If 20% of the investor’s IRA holdings are non-deductible contributions, 80% of any converted amount is taxed, even if the conversion involved just one IRA that had no non-deductable contributions.
Using the loophole
As a result of these rules, a person earning too much to open a Roth could open a traditional IRA and then quickly convert it into a Roth to benefit from tax-free compounding.
Unless the investor already had traditional IRAs with substantial holdings subject to tax, the conversion could be tax-free. There would be no tax on contributions to the traditional IRA since they were non-deductible. There would be no tax on investment gains because the traditional IRA would not yet have any gains.
Opening a traditional IRA in order to quickly convert to a Roth probably would not make sense for an investor who already had traditional IRAs with lots of investment gains and deductible contributions. Those IRAs would be added to the new IRA to figure the taxable portion of any converted amount, creating a big conversion tax.
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