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I’ve written previously about that fact that the income limits for Roth IRA conversions are going away in 2010. Given that we’re over the income threshold for making Roth IRA contributions, this seemed like great news…
After all, we could just go ahead and make non-deductible contributions to our a Traditional IRA over the next few years and then convert those funds into a Roth IRA in 2010. At first blush, the only thing that we’d owe taxes on at that point would be earnings on our contributions, as we’d have already paid the taxes on the contributions themselves (remember, if you’re over the Roth contribution limit, then you’re over the Traditional IRA deductibility limit).
Abolishing Income Limits for Roth IRA Contributions?
Going forward, this change effectively abolishes income limits for Roth IRA contributions. Or does it? Unfortunately, there’s a pretty major gotcha that people need to be aware of before trying to pull this off… As it turns out, the taxable portion of your conversion is calculated by first pooling all Traditional, SEP and SIMPLE contributions and calculate the overall percentage of tax-deferred funds. You then pay taxes on that percent of your conversion as opposed to being able to designate that it’s your non-deductible contributions that you’re rolling over.
In other words, it’s not enough to set up a dedicated Traditional IRA to hold your non-deductible contributions until you make the conversion. Rather, as long as you have other non-Roth IRAs, that money will need to be factored in when figuring up the taxable amount of the conversion.
The following snippet from Fairmark.com explains the situation quite well:
“…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 it 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 will be 96% taxable.”
And yes, I’ve confirmed that “traditional” in this case applies to SEP and SIMPLE IRAs, as well. So unless you’re starting from a clean slate, with no other IRA holdings, you could end up owing a lot more taxes than you expected come 2010.
As with most tax situations, there is an effective (albeit somewhat inconvenient) workaround… If you happen to have tax-deferred money sitting around in a non-Roth IRA you can shield it from this rule by rolling it over into a non-IRA employer plan. Check with your employer about doing this with your 401(k), but be aware that they can’t accept any non-deductible money, and many just plain won’t allow it. Another option would be to open a Solo 401(k) and then roll your non-Roth IRA funds into there. All except for the non-deductible contributions, of course, as that’s what you’ll want to convert into the Roth account.
So is it worth the trouble? I’m still undecided. It would be great to get around the Roth contribution limits, but this is a pretty inconvenient way of doing it. Beyond that, there’s no guarantee that the tax laws will remain unchanged through 2010. While even non-deductible IRA contributions have their advantages, you lose a ton of flexibility, and you don’t necessarily gain much that couldn’t be achieved through tax efficient investing.