Taking the Back Road to Roth

File your taxes, pay your taxes, let’s face it, you have a lot to do by April 15, 2009.

There is one other thing you might want to consider doing on or by April 15, 2009 and that is fund your IRA for 2008. That’s right, the IRS says that you have until April 15, 2009 to make a 2008 contribution to your IRA. This rule applies to both Roth and Traditional IRAs. The contribution limit for a 2008 IRA contribution is $5,000 if you are under 50, and $6,000 if you are age 50 or over. You can make a contribution up to these amounts as long as you have at least that much earned income. However there is a catch, if your adjusted gross income is above certain thresholds (limits depend on filing status), you probably already know that you can’t contribute to a Roth (after tax) IRA, and can’t deduct a contribution to a traditional (tax deductible) IRA

So what are you to do if you can’t contribute to a Roth and can’t deduct contributions to a Traditional IRA? The answer: Contribute to a non-deductible IRA.


Types of IRAs, a Quick Breakdown:
When an investor funds a traditional IRA they can sometimes deduct contributions made to that account. The investments then grow tax-free until retirement (age 59 ½) and are taxed at the regular income tax rates of that time upon withdrawal.

When an investor funds a Roth IRA however, there is not an immediate tax deduction. However, investments grow tax free until retirement (age 59 ½), and are then withdrawn tax-free. A great tool if you think you will be in the same tax bracket, or a higher tax bracket when you are planning on withdrawing assets.

If an investor opens a non-deductible IRA, they are essentially using a traditional IRA but foregoing the tax deduction. Then, upon retirement, (age 59 1/2 ) money is withdrawn using a ratio of contribution to investment earnings. For example, if an investor contributes $40,000 to a non deductible IRA that grows to $100,000 by retirement, 60% of all the withdrawals from that account are taxed as ordinary income. The remaining 40% of withdrawals are considered a return of basis to the investor and not taxed.


Until recently, contributing to a non-deductible IRA was barely worth investigating because you couldn’t deduct contributions, you can’t fund at a very high level, and withdrawals were partially taxable upon retirement, so why even bother?


Here’s why to bother:
In May of 2006 President Bush signed a bill that lifted the income limitation on Roth IRAs in 2010. This means that in 2010 there will be no income limitation on people who would like to convert their traditional IRAs to Roth. So in preparation for this magical year in financial planning, it could be appropriate for some clients to fund traditional (non-deductible) IRAs each year until the 2010 income limits are lifted. This will allow contributions to be built up for a few years then converted to a Roth IRA.


Getting in through the back door:
As I mentioned above, it may be appropriate for some clients to examine opening non-deductible IRAs to fund for the next few years until 2010. This way, in 2010 when the income limit on Roth IRA conversions is lifted, investors will be able to convert their non-deductible IRAs to Roth IRAs, paying only the tax on what investment gains the non-deductible IRAs will have experienced in those few years. Best of all, you don’t have to pay all the tax in 2011. The IRS has decided to let you split the tax on the a 2010 Roth conversion, paying half if 2011 and half in 2012! This is true as long as the funds aren’t immediately withdrawn from the Roth IRA following conversion.

Once the conversion to Roth is made, the investments can be withdrawn upon retirement tax free. In essence, using the non-deductible/Roth conversion strategy, allows investors who ordinarily wouldn’t be able to take advantage of the benefits of a Roth to get some of their retirement funds in position to take advantage of Roth tax treatment.

What if I already have a traditional IRA where some contributions have been deducted and some have not:

If you are like many investors, you probably have made some deductible contributions and some non-deductible IRA contributions. Unfortunately, for purposes of converting a traditional IRA to a Roth, the IRS does not separate deductible and non-deductible IRAs and all IRA earnings will be prorated to calculate tax in a conversion situation. This puts the burden of calculating basis in the IRA and historic deductibility on the shoulders of the investor. Furthermore, if contributions were deducted, they will be treated as earnings for purposes of a conversion. This means that you will have to pay tax at conversion on contributions you previously deducted as well as the earnings.


However, this is but only a minor setback. If you have a traditional IRA and want also to fund a non-deductible IRAs for the coming years, it may be possible (depending on plan provisions) to roll your traditional IRA into a 401(k). Once done, new IRAs could be opened and funded as non-deductible. This way, in 2010 your old IRAs are out of the picture (and into your 401(k)) for conversion purposes, and you only convert what you know to be non deductible.

Funding a non-deductible IRA until 2010 can be a very beneficial technique. If taken advantage of, using this strategy could allow you to establish a small, after-tax nest egg that can grow in the coming years tax free and be withdrawn at retirement with no tax. I encourage you to examine this option if you think it will work for you.