Manna from Heaven

The benevolent IRS has presented us with a gift that we all should consider accepting, especially baby boomers reaching the end of their saving years. Currently, taxpayers may not convert traditional IRAs (deductible and nondeductible) into Roth IRAs if their incomes exceed $100,000 and may not contribute to Roth IRAs if their incomes exceed $166,000 (for married couples filing jointly) or $114,000 (for singles and heads of household). Households may contribute to nondeductible traditional IRAs, however, regardless of their income level.

The Tax Increase Prevention and Reconciliation Act of 2006 eliminated the income limits on Roth IRA conversions starting in 2010, while leaving the income limits on Roth IRA contributions in law. But by lifting the income limits on conversions, the tax act effectively eliminates the income limits on contributions to Roth IRAs as well, by making possible a two-step process that circumvents those limits.

High-income households first would be able to contribute several thousand dollars every year to nondeductible traditional IRAs, for which there is no income limit. Then, starting in 2010, they could convert their nondeductible IRAs to Roth IRAs.

Consider a married couple over age 50, with income above the $166,000 Roth IRA contribution limit. Each year, beginning in 2007, the couple could contribute $10,000 to nondeductible traditional IRAs. The amount that the couple could contribute would rise to $12,000 a year in 2008 and increase with inflation thereafter. Then, beginning in 2010, the couple would be able to roll over the amount that had accumulated in the non-deductible IRA into a Roth IRA (paying tax only on the returns the IRA account had earned to that point), and all earnings on the Roth IRA from that point forward would be forever tax free. For conversions done in 2010, the taxes can be spread equally over two years and included in income in 2011 and 2012.

Yes, that’s right folks–no tax due in 2010 (the year of conversion). The U.S. Government is giving an interest-free loan to build a tax-free savings account. The tax reporting for non-deductible IRAs is a pain in the neck but well worth the effort. IRS Form 8606 should be filed with each year's tax return.

Moreover, in every year after 2010, the couple could deposit $12,000 in a non-deductible IRA, roll over these funds into its Roth IRA the very next day, and pay no tax on the amount converted (since the conversion would be from a non-deductible IRA containing contributions made with after-tax dollars). This process could be repeated every year. Over time, the couple could build their Roth IRA to a very substantial level, with the account being permanently sheltered from taxation.

Whenever you convert, even in 2010, you can’t just roll over the non-deductible IRAs to a Roth IRA and pay no tax at all. If you have other IRA funds (even in other accounts), then you have to factor in those funds, and some funds converted will be taxed based on the tax-free funds compared with the total amount in the IRA. If conversion taxes are expected, clients should be saving for the taxes now.

If one spouse has substantial IRAs, then the spouse with a small IRA or no IRA should fund a non-deductible IRA keeping in mind a future Roth conversion. In any case, both spouses should still contribute. Please keep in mind the timing of company retirement plan rollovers when considering a non-deductible conversion. While in the company retirement plan, the funds are not considered an IRA account for conversion purposes. Remember, there are not any lifetime required distributions for Roth IRA owners, and if tax rates rise, which is very likely, the value of tax-free Roth accounts will increase greatly.

This article is based on current federal tax law. Please consult a tax adviser to discuss your tax planning considerations.