Roth Conversion Strategy For Those With Higher Incomes

As of right now, those who file jointly, with Modified Adjusted Gross Incomes of over $160,000 ($110,000 for single filers) cannot contribute to a Roth IRA. They may still contribute to a non-deductible traditional IRA. However, the problem with this is that there’s no tax benefit upfront and the withdrawals will be taxed at retirement.

In a few years there will be a way around all this! Here’s how:

According to the Tax Increase Prevention and Reconciliation Act of 2005 (here’s a link to a Wikipedia entry on the act) that was signed into law earlier this year, beginning in 2010 conversions to Roth IRAs will be allowed by anyone, regardless of income. As of right now, conversions are only available to those with Modified Adjusted Gross Incomes of less than $100,000. So, until then, a person could contribute to a non-deductible traditional IRA for 2006 – 2009 and then convert that IRA to a Roth IRA in 2010 and pay the income tax on the conversion in 2011 and 2012.

Keep in mind that those who do the conversion will have to pay ordinary taxes on everything but your original contributions (known as basis). So, if a person contributes $4,000 per year to a non-deductible traditional IRA for years 2006 – 2009, their basis is $16,000. If the account is worth $25,000 in 2010 when they convert it to a Roth IRA, they will have to pay ordinary income taxes on $9,000 ($25,000 – $16,000 = $9,000). But, the taxes on that $9,000 can be spread out over two years (2011 and 2012), which will add $4,500 to income over those two years.

Who would want to do such a thing?

  • Young high-income earners who have a long time until retirement.
  • Those who like the the flexibility of the Roth IRA. For instance, with a Roth IRA there is NEVER a required minimum distribution unless the Roth is inherited. Also, Roth IRA withdrawals DO NOT count when figuring taxation on Social Security benefits during retirement.
  • Those who think they will be in a higher tax bracket during retirement.

I’m sure I’ll be writing more on this in the future.

16 thoughts on “Roth Conversion Strategy For Those With Higher Incomes”

  1. An interesting option that I had not thought of. Would it do any good for someone in their early 50s though? I wonder how you would figure that out.

  2. I look forward to hearing more on this topic.

    I often wonder what I should do — I’m currently in grad school, not eligible for 403(b). (My husband maxes out his 403(b).) We make about $80k HHI, and we hope to be in a higher tax bracket when we retire. I agonize over whether I should be putting some of our monthly savings into a post-tax retirement fund, or just stick with standard investments?

    This will probably become more of a concern for us once I leave grad school, and HHI should be around $160k.

  3. jeff,

    A person can have both and can contribute to both, as long as the combined contributions don’t go over the maximum contributions.

  4. I’ve read a couple articles suggesting that this “loophole” may be closed before 2010. That’s what has kept me from taking advantage of this — I don’t want to be stuck with a couple of traditional IRA accounts with relatively little money in them, particularly given the extremely unfortunate tax consequences of traditional IRA contributions (i.e. no tax-deferral, and any earnings are taxed at full income tax rates rather than dividend/capital gains rates).

  5. What is the best way for someone to learn about investing? I have all my other personal finance ducks in a row now I want to learn how to make extra money really work for me.

  6. samerwriter,

    It’s true that any “loophole” can be closed at any time. However, even if this were to be closed, the worst that someone would do is to have 4 years worth of contributions in a non-deductible traditional IRA. You will still get tax-deferred growth but you will pay taxes going in and coming out. You’ll still do better than you would in an annuity.

  7. I can’t think of any way that having non-deductible contributions in an IRA that cannot be rolled into another instrument is better than simply having that same money in a taxable account.

    I’m not sure what the relevance of an annuity is. The same money invested in a stock fund outside of the traditional IRA will be taxed at capital gains and dividend tax rates. That money in a traditional IRA will be taxed at income tax rates. Capital gains and dividend rates for high income people (for whom this loophole is applicable) are usually substantially lower than income tax rates.

    So, without the advantage of an up-front tax deferral, a traditional IRA contribution that cannot be rolled into a Roth is likely to be worse than putting that same money into a taxable account.

  8. There are many factors that you need to think about before you do the conversion. You need to make sure that there will be enough appreciation in your account for it to make any sense at all. So that is why JLP said mostly for younger people. 50 I would say would be okay depending on when you want to retire, what tax bracket you currently fit into, other types of retirement accounts you posses so you can let the Roth grow for as long as possible. This is also a great strategy for people that want to pass on their IRA to their heirs because there are no mandatory withdrawals with a Roth. You need to check with your tax consultant before you just get up and decide to switch over in 2010. Could be a big mistake.

  9. Samewriter: It’s doubtful that this “loophole” will change. It was built into the bill intentionally because it will create a tax windfall for the IRS in 2011 and 2012.

    As for non-deductible IRAs and annuities, the advantage of delaying taxation can be huge depending on time horizon even if it does mean paying ordinary income tax rates vs. capital gains rates. Do the math.

  10. An interesting strategy is if you have a big IRA from a rollover 401K, you’ll be able to Roth-ize it in 2010. If you are self-employed and have a SEP-IRA or self-employed 401K, you can do it and still keep your SEP-IRA or 401K – by closing one plan, rolling it over, and opening up a new one. It would be a fair bit of song&dance, but it could well be worth it.

    As for the “being in a bigger tax bracket in retirement” argument, I’ve always been suspicious of it. A better argument is to use “Roth-ization” as a hedge against – likely – downstream tax increases, which could well put you into a higher tax rate on retirement, even if you aren’t rolling in the lap of luxury.

    Of course, Congress could decide that Roths are too good to be true – or, more interestingly, could change the tax scheme from income-based taxation to consumption-based taxation, which would be the right thing to do but would hoze lots of people with income-tax-advantaged retirement vehicles.

  11. This doesn’t work too well if you have substantial amount in a rollover IRA from previous 401k’s. You have to roll the rollover IRA into another 401k in 2009, convert your non-deductible IRA in 2010, and wait until you change jobs again after 2011 before you can liberate the money from your 401k again. Because most 401k’s have higher cost than what you can get in an IRA, your money can be trapped in the 401k for a long, long time you happen to like your job.

    If you have a high income that doesn’t allow you to contribute to Roth IRA now, that means your tax bracket is already high. It’s hard to imagine that your tax bracket will be even higher than today when you retire.

  12. Has it been determined that a Roth conversion is more beneficial than keeping the assets in a tax-deferred retirement plan?

    All things being equal (and they never are), there is absolutely no difference between paying tax now (as in a Roth) or in the future (QP/IRA). Try it; use any interest rate, any time period, and any tax rate. Will taking advantage of the Roth distribution rules be advantageous; is it needed? Will tax rates decrease or increase? Will the Roth taxation rules changes (like social security did)? Will Roth Legacy trusts be established?

  13. I am thinking of converting some Traditional IRA money to a Roth in 2010. I understand the tax can be delayed until 2011 and 2012, but I can’t find the details. Can part of the tax bill be paid in 2010 and the rest in 2011 and 2012? Could I pay different amounts in the two or three years?

  14. Is there any reason a high income individual cannot make maximum non deductible IRA contributions every year ( 2010, 2011 and so on) and immediately convert to a Roth, thereby bypassing the AGI limitation?

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