How to Convert a Non-Deductible IRA to a Roth IRA

For high earners, there is still a way to leverage the potential of tax-free earnings.

Writing this last year, I was not ready to publish it.  Thanks to the bickering of our extremely productive members of federal government, it was uncertain if the same tax assumptions I was working with would be valid much longer.  With an extension in tax cuts for all but the top earners, I can now release some helpful tips on how to save in a Roth IRA if you are above the limits.

A little background – For a refresh, a Roth IRA allows you to save your after-tax dollars for retirement in an account that can grow tax free and is withdrawn tax free after age 59 ½.  Your ability to contribute to a Roth IRA phases out between 112,000-127,000 for individuals and 178,000-188,000 for married couples filing jointly. More details on Roth IRA income limits.

So you want to contribute to a Roth IRA, but you make too much money, and your employer doesn’t offer a Roth 401(k), eh? If your Adjusted Gross Income (AGI) is above the limits, you can’t contribute directly to a Roth IRA for 2013. But what if you REALLY want to contribute to a Roth IRA? There is a way!

Non-deductible Traditional IRA contributions allow high income earners to get some of the tax benefits of IRAs, but not all of them. Money put into a Traditional IRA is normally tax deductible, grows tax deferred, and is taxed when you make withdrawals in retirement. As the name suggests, non-deductible IRA contributions don’t qualify for tax deduction, but earnings are not taxed, and only the growth is taxable when you take it out in retirement.

Roth IRAs are not tax deductible either, but the growth is never taxed. You can see why someone would like to have at least some of their money in a Roth IRA as opposed to having non-deductible IRA contributions… there is a possibility for huge tax savings on the growth! This is why many people would want to convert their non-deductible IRA contributions to a Roth IRA.  Of course, these tax savings will vary based on retirement income levels versus current earnings, future tax rates, etc.  BUT, having a Roth IRA in your arsenal is, at the least, another way to spread out your proverbial eggs to better prepare for the unknown.

As recently as 2009, you could only convert an IRA to a Roth IRA if your income was below $100,000. But in 2010, those limitations were eliminated so now there are NO income limits on IRA conversions.  In fact, in order to raise a little more tax moo-la, Washington has now decided that you can also convert your traditional 401(k) to a Roth 401(k) if you so choose and your employer allows.  Whether a full or partial conversion is the right idea for you or not will be up to you, your advisor and your CPA, but it is something to consider.

So if you want to put money into a Roth IRA, but make too much money, here’s what you can do:
Step 1: Open new Traditional IRA
Step 2: Make a non-deductible contribution to your IRA (Maximum of $5,500 for 2013 (Woohoo, they raised it!), $6,500 if over 50)
Step 3: Open new Roth IRA
Step 4: Tell the custodian of your IRA that you want to do a Roth conversion

That’s it! Plus, you can do this for each you and your spouse… There are a couple of things to remember when doing the conversion:

After contributing to the non-deductible IRA, wait at least 30 days before converting to the Roth IRA. Some experts recommend waiting until the next year. This helps establish a paper trail of the conversion.

Be sure to open a new Roth IRA for the conversion. If the IRS calls the conversion into question, the entire Roth IRA might lose its preferred tax status. You don’t want to expose your current Roth IRA to this risk.

Don’t forget to file Form 8606 with your tax return. If the IRS ever comes a-calling, you need to be able to prove that you contributed to a non-deductible IRA. Form 8606 is the proof you MUST have.

Be sure you consult with a financial advisor and/or an accountant before implementing this strategy, especially if you have a Traditional IRA as you may expose yourself to additional taxes.

So what do you think? Thinking about implementing this strategy? Let me know your thoughts or questions!