Non-deductible IRAs finally have value

By David Flinchum, CPA

A little-known provision in the Tax Increase Prevention and Reconciliation Act (“TIPRA,” signed into law in May 2006) propelled non-deductible IRAs to the forefront of tax and financial planning on behalf of high-income individuals.

TIPRA was highly publicized for extending the lower tax rates on capital gain and dividend income beyond 2008. It also increased the exemption for the dreaded alternative minimum tax. Not so publicized were TIPRA’s revisions to the rules regarding the Roth IRA.

A Roth IRA has many advantages over a traditional IRA. For example, qualified distributions from a Roth IRA are never taxed (including an inherited Roth IRA) and minimum required distributions are not required from a Roth IRA.

Currently, a worker may contribute annually to a Roth IRA if his or her income does not exceed $110,000 ($160,000 if married filing joint). Further, one may not convert his or her traditional IRA to a Roth IRA if his or her income exceeds $100,000. Because of these income thresholds, most high earners cannot participate in a Roth IRA.

401(k) plans may offer a Roth deferral option, but most taxpayers find it difficult to forego the tax savings afforded by non-Roth deferrals.

Further, because most high earners participate in an employer-sponsored retirement plan (401(k), SEP, pension plan, etc.), they are barred from making deductible IRA contributions. For those who wish to make an annual IRA contribution, their only choice is a non-deductible IRA. For reasons that won’t be explained here, a non-deductible IRA has limited income tax advantages and generally is not recommended.

Beginning in 2010, TIPRA removes the $100,000 income threshold for converting a traditional IRA to a Roth IRA. Therefore, in 2010 and beyond, any owner of a traditional IRA may convert his or her account to a Roth IRA, regardless of income.

The downside of a conversion is that previously deducted IRAs are taxed in the year of the conversion. For that reason, conversions generally are undesirable. I prefer to maintain the traditional IRA and continue the tax-deferred growth, and withdraw the minimum required distributions beginning at age 70½.

So why is a non-deductible IRA suddenly attractive? The answer is that when a non-deductible IRA is converted to a Roth IRA, only the appreciation in the non-deductible IRA is taxed at the time of conversion. The elimination of the income threshold in 2010 permits virtually everyone with earned income to take advantage of the Roth IRA in 2010 and beyond.

Further, the tax on a Roth IRA conversion occurring in 2010 may be paid in two installments – half in 2011 and half in 2012. This results in postponement in payment of the tax to the two years following the year of conversion.

Let’s review the annual IRA contribution limits:

2006: $4,000 maximum under age 50; $5,000 for age 50 and older
2007: $4,000 maximum under age 50; $5,000 for age 50 and older
2008: $5,000 maximum under age 50; $6,000 for age 50 and older
2009: $5,000 maximum under age 50; $6,000 for age 50 and older
2010: $5,000 maximum under age 50; $6,000 for age 50 and older
Totals: $23,000 maximum under age 50; $28,000 for age 50 and older

Because of TIPRA, one may make a non-deductible IRA contribution for the years 2006 through 2010. For a person younger than 50, cumulative contributions may total $23,000. Let’s say that the IRA grows to $27,000 in 2010 and the IRA is converted to a Roth IRA. A total of $4,000 would be taxed ($27,000 less $23,000) and the resulting tax would be paid half in 2011 and half in 2012.

If married, both spouses may contribute, essentially doubling the benefit.

The opportunity does not stop in 2010. In each year thereafter, under current law, one may make a contribution to his or her nondeductible IRA, then immediately convert it to a Roth IRA. There would be no taxation on the conversion because the non-deductible IRA contribution is not given time to generate an investment return.

Special rules apply at the time of conversion when someone has both a deductible and a non-deductible IRA. For purposes of calculating the income resulting from the conversion, one must apportion the cost basis among all IRAs. A way around this apportionment may be to roll over the deductible IRA into a qualified retirement plan (if available) prior to conversion.

Is this a tax loophole? Clearly. Will congress take away this loophole? Maybe. The Roth conversion is a revenue raiser, so congress might leave it alone. But for now, the tax regulations permit essentially all workers to avail themselves of a Roth IRA, by following these steps.

David Flinchum, CPA, works with Berlin, Ramos & Co., P.A.

Contact this Author: < David Flinchum > dflinchum@berlinramos.com

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