Roth IRA Workaround: 2010 Conversion Limit Loophole
Can’t contribute to a Roth IRA? There’s a workaround.
I was speaking my accountant a few weeks ago when we began discussing retirement options. One of the ideas we discussed was to contribute to a non-deductible Traditional IRA with the plan of converting it into a Roth IRA in 2010. Prior to 2010, if you earned more than $100,000 MAGI, you cannot convert a Traditional IRA to a Roth IRA. This limit is the same whether you’re married or single (boo!). Starting in 2010, that rule disappears so anyone of any income can convert (more on the 2010 traditional IRA conversion income limit loophole).
Right now, my wife and I cannot contribute to a Roth IRA and so we lose access to one of the greatest retirement vehicles available. Fortunately she has access to a 401(k) and I have access to a SEP-IRA, so we do have pre-tax retirement accounts; we just don’t have post-tax vehicles like the Roth IRA. So how do we get some? Use that loophole!
Here is our strategy to take advantage of the 2010 rule change, we will both contribute to non-deductible Traditional IRAs and then convert them, nearly tax free, to Roth IRAs in 2010. It’s nearly tax free because we would still be responsible for taxes on any appreciation the IRAs saw. In talking with my accountant, this strategy works but he gave me some pointers to ensure we don’t run into any headaches.
- Separate the Traditional IRAs from any other retirement assets. He advised that we open separate accounts from both each other (this is required, you can’t have a joint IRA) and from any other retirement assets. This will give us the greatest flexibility in the future. If we were to mix our non-deductible Traditional IRA with my SEP-IRA (I took a deduction for those contributions), I can’t decide to convert just the “non-deductible” part of that mix.
- Remember to file IRS Form 8606. My accountant said that a lot of filers who go the DIY route often fail to submit this form and this can cause big headaches down the road. Form 8606 covers non-deductible IRAs and it’s the only way you can tell the IRS that you contributed to a non-deductible Traditional IRA; they won’t know otherwise. Deductible IRA contributions are recorded as a deduction and the IRS doesn’t care about Roth IRAs.
- You don’t have to convert all at once. This is more an explanation of the rule than advice on what to do but you don’t have to convert all the assets in one shot. You can spread it across two years. This wouldn’t matter to us for our non-deductible Traditional IRAs but if we opt to convert any of our Rollover IRAs, we could spread the damage across two years.
Now we have to hope that the rule doesn’t change or those non-deductible Traditional IRA dollars will be taxed again… in 40-something years.
Has anyone else looked into this?
(Photo: scottwills)
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Another strategy to consider (if you have a Health Savings Account) is to use the HSA as a Roth type-investment. If you do not use the HSA funds for current medical expenses, those funds will grow and can be withdrawn in retirement, entirely tax free, as reimbursement of past and present medical expenses, including Medicare premiums. It’s actually better than a Roth IRA because you don’t pay tax going in either.
You may want to doublecheck the rules, but I thought that when you convert, even if you have separate IRAs, you need to allocate a percentage of your conversion as deductible that matches the percentage of ALL of your IRAs that are deductible. Maybe it’s different with a SEP, but as I understand it, if you have a deductible IRA that is $80,000 and a non-deductible IRA that is $20,000, if you want to convert $20,000 to a Roth, $16,000 (80%) needs to be considered deductible. Again, I may be wrong and/or the case may be different with a SEP, but that’s how I remember it.
My accountant told me that putting them in a separate account will be sufficient for that purpose…
Jim, take a look at the article from Nickel: http://www.fivecentnickel.com/2007/10/18/look-before-you-leap-roth-ira-conversions-in-2010/
Or look at example #3 here: http://www.money-zine.com/Financial-Planning/Retirement/2010-Roth-IRA-Conversions/
I also checked a couple other places, and it looks like you need to allocate deductible and non-deductible on a pro-rata basis.
Jim, I did a bit more research and tried to post a comment with a couple links to articles that showed that you DO need to allocate non-deductible and deductible IRAs (including SEPs) on a pro-rata basis (regardless of whether they are separate accounts), but I think the urls were causing my comments to be blocked. If you google “roth ira conversion 2010″, some of the first few articles do mention this. Just want to make sure you know in case it changes your plans. Thanks.
Hmmm I’ll have to check back with my accountant to see if we had a misunderstanding. I appreciate all the research you did, I’ll let you know what he says.
I do not qualify for a roth, so I started contributing to a non-deductible IRA in 2006. I plan to convert to the Roth in 2010. Fortunately, I do not have any traditional IRAs so i do not have to worry about the pro-rata allocations. I did read about that when I was researching this issue a couple of years ago, but I have to admit i don’t completely understand it.
Jim-
Yes, I just wrote an article about this on my blog today. All IRA monies must be converted pro rata unfortunately. It also includes a couple work arounds…not sure how helpful it will be to your situation specifically.
http://daseducation.wordpress.com/2008/09/09/when-converting-a-traditional-ira-to-a-roth-ira-in-2010-beware-of-the-glitches/
Jim,
We’ve been using a conversion strategy over the last 10 years to move money every other year. You do need to consider all accounts as one like the others said and treat it pro-rata.
However, there is a strategy where you can move your deductible IRA money to a 401k if you have one and it allows such a transfer. Leave only the after-tax money, and then convert it.