Roth IRAs — Life After Conversion

In December we featured an article on ROTH IRA conversions that covered the basics of conversion. This article discusses life after that conversion, including the benefits of annual conversions.

All taxpayers are eligible to convert traditional IRAs to Roth IRAs commencing January 1, 2010. Even though all taxpayers with wage income, alimony or self-employment income (collectively referred to as "earned income") can contribute $5,000 (an additional $1,000 for taxpayers 50 or older) to a traditional IRA, they are not necessarily allowed to contribute directly to Roth IRAs; however, they are eligible to convert their traditional IRAs to Roth IRAs. With the use of a traditional IRA and nondeductible contributions, taxpayers with modified adjusted gross income greater than the prescribed limits can in fact put money into a Roth IRA.

The contributions to Roth IRAs are limited based upon a taxpayer's income. Single taxpayers may contribute $5,000 ($6,000 in the case of 50 or older) to a Roth IRA if his or her modified adjusted gross income does not exceed $105,000. If his or her modified adjusted gross income is more than $120,000 then no amount can be contributed to a Roth IRA. If the modified adjusted gross income is between $105,000 and $120,000 then only a portion of the amount can be contributed. For married individuals, the maximum amount can be contributed to a Roth IRA only if the modified adjusted gross income reported on the joint income tax return is $167,000 or less and no contribution can be made if the reported modified adjusted gross income exceeds $177,000. A partial contribution can be made if the modified adjusted gross income is between $167,000 and $177,000.

In contrast, all taxpayers who have earned income (including alimony) can make contributions to traditional IRAs. Contributions, however, cannot be made to a traditional IRA after the taxpayer has attained age 70 ½. The issue is whether the contributions are deductible or not deductible. If a taxpayer or the taxpayer's spouse is not an active participant in a qualified retirement plan, then, regardless of the amount of income, deductible contributions can be made to a traditional IRA. However, if the taxpayer (and if the taxpayer is married - his or her spouse) is an active participant in a qualified retirement plan, then whether the contribution is deductible depends on the level of their adjusted gross income. Even if only one spouse has earned income, a contribution can be made to the IRA of the spouse who does not have earned income. A taxpayer can designate any traditional IRA contribution as a nondeductible contribution even if the contribution is otherwise deductible.

To avoid the Roth IRA income limitation, single individuals and married individuals who have income in excess of the income limits can accumulate money in a Roth IRA by first making a nondeductible contribution to a traditional IRA. After the nondeductible contribution is made to the traditional IRA, the traditional IRA is converted to a Roth IRA. By making the nondeductible contribution to the traditional IRA and then immediately converting the traditional IRA to a Roth IRA, no taxable income would generally be recognized. However, be aware that if the individual has other traditional IRAs, income will be recognized upon the conversion because all IRAs need to be aggregated when distributions are made. Part of the converted amount will include amounts from the IRA consisting of the nondeductible contributions and amounts from the other IRAs.

For individuals who are otherwise saving $5,000 per year ($6,000 if 50 or older), it could make financial sense to make nondeductible contributions followed immediately by a Roth conversion, as this will allow them to accumulate income tax free money.

These contributions can be made regardless of whether the individuals participate in a qualified retirement plan. However, individuals who have other traditional IRAs, including simplified employee pension plans (SEPPs), may not benefit from this because all traditional IRAs have to be aggregated for purposes of determining the amount of income that is required to be recognized upon the conversion to a Roth IRA.

Assume an individual (age 35) has wages of $350,000 and the amount of the modified adjusted gross income reported on her joint income tax return with her spouse (also age 35) is $500,000. The two individuals do not have any traditional IRAs. Since their income exceeds $177,000, they are ineligible to make contributions to Roth IRAs. However, they can each make a $5,000 nondeductible contribution to a traditional IRA. After the contribution is made, the traditional IRA is converted to a Roth IRA. Since the amount converted is $5,000 and their respective basis in the traditional IRA is $5,000, no income is recognized on the conversion. If each taxpayer survives until age 80, the current year contribution will be worth approximately $45,000 (assuming a 5% investment return) at that time which can be passed on to the heirs income tax free. If each spouse made the $5,000 contribution and did the conversion every year until age 70 ½, the amount in their respective Roth IRA at age 80 would be $820,000 (consisting of $180,000 of contributions and $640,000 of investment earnings – 5% investment return). On the other hand, if each spouse were to invest the $5,000 in a taxable investment, each spouse would have approximately $347,000 less than in the Roth IRA if they were in a 35% tax bracket.