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Wednesday, April 9, 2008

How to Get a Roth IRA if You Make Too Much Money

I like loopholes. I also like Roth IRAs. So, it seems logical that I’d like a Roth IRA loophole and I’ll share this one with you. First, a little background: Roth IRAs are a tax-free retirement account. You make a non-deductible contribution into the Roth IRA and the future growth and withdrawals are tax-free. Roths are excellent saving vehicles if you will be in the same or higher tax bracket at the time you will withdraw your money. In addition, Roths do not require you to take annual “Minimum Distribution” starting at age 70 ½ like the other types of IRAs… you can accumulate money for a very long time with tax-free growth. For example, if my daughter Arielle started a Roth today (she’s 16) and contributed for the years 2007-2012 (when she hopefully graduates from college), she’d have about $38 K when she got out of college. But, if her father accidentally forgot to tell her about the account (oops!), the Roth would continue accumulating to the point where she would have $693K at age 65 and $2.7 million at age 85. All tax free.

That’s not the only way you can get into a Roth. You can convert an existing IRA to a Roth. To do this, you need to pay the taxes on the money you transfer from your traditional IRA to your new Roth. Roth conversions can get a whole bunch of money into a Roth (with probably a whole bunch of taxes on the conversions… but there is an interesting “twist” we are getting to.)

Ah, but there’s a catch. You can only contribute to a Roth if your income (a weird thing called Modified Adjusted Gross Income) is under $101,000 for single filers and $159,000 for joint filers (this is oversimplified, as usual, since you can partially contribute to a Roth if you income is in a range of $101,000 to $116,000 for singles and $159,000 - $169,000 for married). Don’t ask me why the range is $15,000 for single people and $10,000 for married. Also don’t ask me why the limit is $101,000 for single people, and not $202,000 for married (Actually, the rules are even more complex than I just described… but you get the picture. Remember, I don’t make the rules, I just try to get around them.) Back to our story, these income limits leave a lot of us who want Roths (and the higher your bracket, the more you want a Roth) but are unable to contribute or convert.

Now, the loophole. There are three kinds of IRAs: Roths, regular deductible IRAs (which also have perplexing income limitations) and nondeductible IRAs. The one I want to focus upon it the nondeductible IRA. From a financial planning perspective, nondeductible IRAs are normally pretty boring: you put in after-tax money, invest it and pay taxes on the earnings when you withdraw them. There is no income limit or other restriction on a nondeductible IRA. Which is what’s interesting. You can contribute to a nondeductible IRA for the years 2007(if you do it before April 15th 2008), 2008, 2009, and 2010. In 2010, the income limit for conversions is lifted. So, say Tom and Sue are 54 and 50 respectively. They each contribute the max to a nondeductible IRA as follows: $6,000 each (a $5,000 regular contribution, plus a ‘catch-up’ $1,000 for being over age 50) for 2008, $6,500 for 2009, and $7,000 for 2010. Assuming they get 7% in a balanced portfolio, their combined IRAs will be worth about $45K by the end of 2010. There will be about $6,300 of income that they will have to pay tax on, so it would cost them about $1,600 to get two Roths worth $45K. If they leave it alone for 20 years, it will grow to about $211,000 tax-free dollars. Not bad for three years of contributions totaling $39K.
Oh, did I mention one other aspect of the loophole? The law allows you to convert in 2010, but pay the tax in two installments in 2011 and 2012. Warning: If you have other IRAs, and you want to do this loophole, recognize that all IRAs must be aggregated. 401(K)s are not included in the aggregation rule. See an advisor to fit your situation. (Gee, can I think of a good one?)

Leon LaBrecque