Most of the IRA news for 2010 focused on converting a traditional IRA to a Roth IRA. But there’s more to consider. For ex-ample: What about people who want to make annual IRA contributions? Is there a way for all of them to contribute to Roth IRAs?
Converting a traditional IRA to a Roth IRA is news in 2010 because the income limit on conversions is repealed. IRA owners of all income levels can convert their traditional IRAs (and employer retirement plans) into Roth IRAs.
The income limits for regular contributions to Roth IRAs, however, still exist. When your adjusted gross income is $120,000 or more and you are single or $177,000 or more and you are married filing jointly, you can’t contribute to a Roth IRA. For those who are allowed to make Roth IRA contributions, the contribution limit is $5,000 for taxpayers under 50 and $6,000 for taxpayers 50 and older.
Those above the income limit shouldn’t give up hope. They still can transfer money to a Roth IRA each year, but not directly.
Here’s how to make Roth IRA contributions through the back door. First, make a contribution to a traditional IRA. You won’t be able to deduct this contribution, so complete Form 8606 for nondeductible IRA contributions. Then, you can convert this traditional IRA to a Roth IRA. I’d wait at last a few months to be sure the paperwork on the IRA is correct. You now have done the equivalent of making an annual Roth IRA contribution, despite your income level.
The tricky part is determining the tax to pay on your conversion. When nondeductible contributions are transferred from a traditional IRA to a Roth IRA there is no tax on them. That leads most people to think they just make the nondeductible contribution and, since the IRA hasn’t generated much of a return, all or most of the conversion is tax free.
Unfortunately, that’s true only if this is your sole traditional IRA.
You don’t choose which assets are transferred when you convert less than the full amount of all your traditional IRAs. Instead, you divide the sum of all your nondeductible contributions still in traditional IRAs by the total value of all your traditional IRAs. The percentage is the tax-free portion of the amount you convert.
Suppose at the end of last year you had two traditional IRAs with a total value of $50,000 and containing no nondeductible contributions. Their value hasn’t changed this year. This year you make a $5,000 nondeductible contribution to a new traditional IRA. Then, you convert the traditional IRA with the nondeductible contribution to a Roth IRA. To determine the nontaxable amount, you divide $5,000 by $55,000 (the value of all your traditional IRAs) and find the result of 9%. So, when you convert the entire nondeductible contribution IRA to Roth IRA only 9%, or $450, is tax free.
To further complicate the matter, the IRS says the value of all your traditional IRAs at the end of the year is used. You won’t really know the tax-free amount until after the year is over.
When you don’t have other traditional IRAs, this is a back door way to contribute to a Roth IRA. First, make a nondeductible contribution to a traditional IRA. Then, convert that traditional IRA to a Roth IRA. But if you want to minimize taxes on this indirect strategy, you can’t have other traditional IRAs.
July 2010. RW