Roth IRA Contributions – An Interesting “Work-Around” to the Income Limits

Monday, March 8th, 2010 by Cass Chappell, CFP®

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[If you are an investor who makes more than the income limit for contributions to a Roth IRA - this MAY be for you!]

 

Many people have Roth IRA’s that they opened in the late 1990’s.  For some, they have been unable to contribute to their Roth IRA since then, due to income limits.  In 2009 and 2010, the income limit for someone to contribute to a Roth IRA (married, filing jointly) is $176,000 and $177,000, respectively.  [This limit is based on Adjusted Gross Income (AGI) and the amount that someone can contribute starts to phase out at $166,000 (2009) and $167,000 (2010)]

In 2009 and 2010, the maximum contribution is $5000 for each year (this amount is higher if you are over 50).

There has always been both an income limit for contributions and a maximum amount that could be contributed.  It has been indexed for inflation each year.

 Conversions from a Traditional IRA to a Roth IRA are a different story.  The income limit has been $100,000 since the inception of the Roth IRA.  In 2010, this limit was removed (much more on this in other postings).  In other words, in 2010 anyone, regardless of income, can convert funds in a Traditional IRA to a Roth IRA.

This has introduced an interesting “work around” to the AGI limit for contributions mentioned at the top of this article.

While I have seen it mentioned in some blogs and other articles, I am surprised that I haven’t seen it more often in the mainstream media.

If you make more than the income limit to contribute to a Roth IRA, this may be for you…………….

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Here is how it works:

1.     Open a Traditional IRA

2.     Make the maximum contribution for 2009 (by April 15th) and 2010 – $5000 for each year, unless you are over 50

3.     Don’t deduct the contribution (I will explain in a second)

4.     Immediately convert the Traditional IRA to a Roth IRA 

5.     Voila!  You have just gotten $10,000 into a Roth IRA when you otherwise would have been forbidden to do so (based on your income)

Since you didn’t deduct the contribution, there are no taxes due on the conversion (unless there was some interest or gain between the time you opened the Traditional IRA and the conversion – that is why I stressed converting immediately after the account is opened). 

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Yes.  I know.  Seems too good to be true!  Well, there is at least one “catch”….

Non-deductible IRA’s are aggregated with all other IRA’s to determine what proportion of the conversion would be taxable.  If you have an IRA rollover from a previous employer (or any IRA that has pre-tax money in it), then at least a portion of the conversion would be taxable.

For that reason, this strategy works best when an investor has NO OTHER TRADITIONAL IRA MONEY.

401(k)’s that are at previous employers don’t count against you…..as long as they are still in the 401(k) – and not in a Rollover IRA.

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