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Nondeductible IRA contributions conversion to Roth?

Is it possible as I come to the higher income bracket. And does I have any advantages to it?

Feb 14, 2012 by vismay from Jersey City, NJ in  |  Flag
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Don't qualify for a Roth? Use the 'back door'!

Those who earn too much to contribute to a Roth IRA can get the same benefits by opening a traditional IRA and converting it. Should you? If your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a back-door way.
Step 1: Open a traditional IRA (in your case, it’s nondeductible). Step 2: Convert it to a Roth IRA.
Is it worth it? "It’s a no-brainer if you have the cash to do it," says Kevin Huston, an enrolled agent in Asheville, N.C. , who has clients young and old doing it to shore up their retirement savings. "It especially makes sense for people who are younger, because they have all these years of tax-free growth." Basically, you get an extra $5,000 (or $6,000 if you’re 50 or older) each year that grows in the Roth IRA income-tax free. That’s $10,000 (or $12,000) a year for a married couple. Repeat each year, and you can amass a nice retirement kitty. The audience for back-door Roth’s is a niche: those earning too much to contribute to Roth’s directly but not so much that the extra tax savings doesn’t seem worth the effort. Vanguard says that "backdoor Roth" contributions represented about 2% of traditional IRA contributions in 2011. Income restrictions on conversions were lifted starting Jan. 1, 2010, so anyone -- regardless of income -- can convert a traditional IRA to a Roth. Why go through the hoops of getting money into a Roth IRA? They are an amazing deal, especially for folks looking long-term and expecting higher tax rates in the future. With a Roth IRA, you don’t ever have to take money out, and when you do start taking money out, it’s all tax-free income, including the earnings.
By contrast, with a traditional IRA, earnings grow tax-deferred, you have to start taking required mandatory distributions the year after you turn 70.5, and distributions count as income. A Roth can help keep your tax bite down in retirement. (Ideally you want a mix of taxable, tax-deferred and tax-free accounts to draw from in retirement.) A Roth IRA also has other benefits. Medicare premiums are based on income, so by keeping your income down, you’ll pay a lower premium. If you leave a Roth account to a child, he or she will have to take money out each year, but there will be no income tax hit. (Inheriting a $100,000 Roth IRA is a whole lot better than inheriting a $100,000 traditional IRA; the higher your beneficiary’s tax bracket, the bigger the savings). Here’s how the strategy can help a real couple in their 40s build their nest egg. The wife’s in marketing with a pharmaceutical company, and the husband is a stay-at-home dad. She’s maxing out on her company pre-tax 401k plan contributions -- putting away the full $17,000 for 2012. Her employer doesn’t offer a Roth 401k option. The couple told Huston, their tax adviser, they want to save more, but they can’t contribute to Roth IRAs directly because her income is nearly $200,000 a year. (Once your modified adjusted gross income is $183,000 for a couple filing jointly or $125,000 for singles, no Roth IRA contributions are allowed.) But they can each contribute to a traditional IRA. They don’t get a deduction because of the wife’s high income, so it’s called a nondeductible IRA. She puts away $5,000, and he puts away $5,000. (His IRA is based on her earnings and called a nondeductible spousal IRA; otherwise you have to have earned income to contribute to an IRA.) Then they convert the IRAs into Roth IRAs.
That sounds complicated, but it’s almost as easy as transferring money from checking to savings. You pay income tax the next April only on any earnings accrued between the time you contributed to the nondeductible IRA and converted to a Roth.

So how do you remove the pretax IRA from the equation? Transfer it to a 401(k). Many employer plans allow “roll-ins” of IRA money to 401(k)s. How does this work? Only pre-tax dollars can be transferred to a 401(k), explains Barry Picker, a CPA and IRA expert in Brooklyn, N.Y. Once you move the pre-tax dollars (and earnings) into a 401(k) that leaves an IRA with no taxable income. “Convert it to a Roth; pay no tax,” Picker says. If your employer 401(k) plan doesn’t allow roll-ins, there’s another option for those with self-employment income: setting up a solo 401(k), and doing the pre-tax IRA roll-in to that plan. If you’re setting up a solo 401(k), make sure the provider accepts roll-ins. Do the transfer, then the conversion. This can even work if you have a small amount of self-employment income, say a side consulting gig you report on Schedule C, even for just one year. There’s still time to make an IRA contribution for calendar year 2011 through April 17, 2012. You can double up and make your 2012 contribution, too.

Comment   |  Flag   |  Feb 14, 2012 from Marlton, NJ

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3 votes

If you have existing pre-tax IRAs, either from contributions you made in previous years or from old 401k roll overs, the decision about whether to convert your after-tax balances to ROTH requires some careful analysis of your specific circumstances, lest you end up with a nasty tax surprise.

For example, Martin's suggestion that you may be able to roll such IRAs into your employer's 401k plan might be a good one, but it depends on the original source of your IRAs and the specific rules and costs associated with your plan. Some plans only permit inbound roll over contributions from previously rolled over employer-sponsored plan accounts. Moreover, if an investor has several hundred thousand dollars of pretax IRAs and a poor quality 401k plan, it would be foolish to roll the balances into a bad plan just to save a few dollars in taxes. Once your retirement savings are locked into an employer-sponsored plan, it may be impossible to roll into an IRA unless you leave the company.

You also should assess your overall tax situation, anticipated investment holding period, and long-term expected rate of return, based on your mix of assets. If your holding period is long enough and your expected return is high enough, it could make sense to convert all available pre-tax accounts to ROTH accounts, in which case future after-tax IRA contributions can be made and converted each year without any further tax implications. If your marginal tax rate is expected to increase, this may be another reason to accelerate taxes by converting now. My point is that while there are rules of thumb about ROTH accounts, they are just that and should not be relied upon. You should review the particular facts of your own situation before making any definitive judgments about your retirement accounts.

After reading Eddie Patel's financial guide about ROTH accounts, you may find it useful to use the ROTH conversion calculator that I have posted as a tool for self-directed investors. It is accessible via the Brightscope Financial Guides under my profile, or it can be viewed here: http://roth.nc.am

2 Comments   |  Flag   |  Feb 14, 2012 from San Francisco, CA

Gr8 Thanks. Conversion calculator is very good. But I am still confused. I left my old employer and Rolled over my 401(k) to IRA. I am pretty sure that I will come to higher tax bracket in 2012 and beyond. Is it a good idea to convert my current IRA to ROTH (by paying TAX) or should I keep money in both i.e. pay tax for 50% and convert to roth and keep 50% into IRA.

Flag |  Feb 15, 2012 near Jersey City, NJ
James P. Dowd, CFA

Dear Vismay - Thank you for the positive comments. There are several factors you should consider: (1) Your marginal tax rate today vs. expected marginal tax rate over the next two years vs. expected marginal tax rate during your retirement. If you are a high earner / high saver and always expect to be in the top bracket, then the issue becomes simpler: you are most likely better off converting now, unless you think tax rates will drop in the futures. If you are uncertain about future marginal tax rates, then you can run some scenarios to see the implications at different income and tax levels. Keep in mind that the model assumes you pay any current income tax from taxable account balances ~ this is a key reason why ROTHs look so attractive. (2) Time horizon. The benefit of tax-deferred or tax-free compounding is a function of both the rate of return and time. If the rate of return is positive, a longer time horizon means a greater benefit. If your time horizon is short, then tax rates become the only important consideration. (3) Expected rate of return. All else equal, a higher rate of return will produce a greater benefit of compounded, tax-exempt returns.

Given the uncertainty associated with all three of these factors, many advisors recommend "tax diversification" --- keeping some of your assets in a deferred IRA and some in a ROTH. Unfortunately, there is no way to optimize discrete scenarios related to future tax rates, which is why you often see a 50-50 recommendation. Before I give my clients definitive recommendations about ROTH conversion, I try to understand their view about future taxes, because my ouija board is no better than theirs! Most of my clients (all?) believe that tax rates in the future will be higher than they are now. I share this view, so I am generally advising clients in the top marginal bracket to convert all of their pre-tax accounts to ROTHs.

I hope this is helpful. Feel free to message me if you would like to discuss further or in more detail.

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Flag |  Feb 15, 2012 near San Francisco, CA

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2 votes

It is possible and I have written a guide on this subject. The advantage of doing it is withdrawing the money tax free when eligible.

2 Comments   |  Flag   |  Feb 14, 2012 from Orland Park, IL

But didn't I have to pay the TAX (25%) for the money I put in Roth (considering I already paid TAX on it as it's my paycheck money?)

Flag |  Feb 14, 2012 near Jersey City, NJ
Eddie Patel, CFP®

You are taxed on the money already simply by the fact that you are first making a "nondeductible" contribution to the IRA. The conversion to the ROTH is not taxable because you are converting "nondeductible" contributions.

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Flag |  Feb 14, 2012 near Orland Park, IL

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