The IRA loophole you don't want to miss

Question: My wife and I contribute to Roth IRA accounts and we hope to retire around age 50. But next year our income will put us over the Roth IRA income limits, so we won’t be able to contribute anymore. So should we just put money in a traditional IRA at that point, a taxable account or, since we have enough income, both? —Dave, Castle Rock, Colorado

Answer: I’ve got some good news for you. Even if your income exceeds the Roth IRA eligibility limits and prevents you from contributing to a Roth IRA next year, there’s still a way for you to get some of your 2009 earnings into a Roth, although you’ll have to wait until 2010 to actually move the money into the account.

Even if your income stays above the maximum allowed for making annual contributions to a Roth IRA in 2010 and beyond, you will still be able to get money into a Roth each year.

How is this possible?

Well, consider it an unintentional gift from the guys and gals inside the Beltway.

Two years ago Congress passed bill that, among other things, eliminated the income eligibility limit for converting an IRA to a Roth IRA. That provision doesn’t go into effect until 2010, however.

Technically, this change affects only conversions. The law doesn’t eliminate the income ceiling for making an annual contribution to a Roth IRA.

But by using a little sleight-of-hand, you can use this new provision to get around the income limits for annual Roth IRA contributions.

Here’s how the ploy works:

Let’s assume you’re correct and that next year your income is too high for you to contribute to a Roth IRA. Not to worry. Just fund a nondeductible IRA, which anyone with earned income who is younger than 70 1/2 can do. (The maximum contribution this year for any type of IRA is $5,000, plus an extra $1,000 if you’re 50 or older.)

Your money won’t be in a Roth IRA - yet. But that’s where the law eliminating the income limits for conversions comes in. Starting in 2010, anyone can convert an IRA to a Roth IRA regardless of how high their income is. So when 2010 rolls around, all you do is convert your nondeductible IRA to a Roth IRA.

Voila! Your 2009 IRA contribution is now in a Roth IRA.

By the way, if your income this year disqualifies you from contributing to a Roth, you can do the same thing this year - that is, fund a nondeductible IRA for the 2008 tax year and convert it in 2010.

Ah, but what if your income continues to exceed the limit for annual Roth IRA contributions in the future? No problemo.

Starting in 2010, you just open a nondeductible IRA and immediately convert it to a Roth. You can continue to do this in subsequent years your income bars you from making a regular annual contribution to a Roth IRA, assuming Congress doesn’t change the conversion rules again. (Memo to Congress: Why not just eliminate the income restrictions for making annual Roth IRA contributions starting in 2010? It’s absurd to make people go through the paperwork of opening one IRA just to convert to another.)

Don't forget about Uncle Sam

Of course, when you convert an IRA to a Roth IRA, you must deal with the issue of taxes on conversions. If you convert a nondeductible IRA right after you establish it - and that nondeductible IRA is the only non-Roth IRA you own - you will owe little, if anything, in taxes. That’s because you’ll pay no tax on your nondeductible contribution itself since that’s after-tax money that’s already been taxed. Only the investment earnings in your nondeductible IRA are taxable. And if the account has been open only a short time, those earnings, if any, are likely to be minimal.

But if you have other non-Roth IRAs in addition to the nondeductible IRA you’ve just opened - perhaps a traditional deductible IRA you funded years ago or an IRA rollover that holds 401(k) money from a previous job, or both - then the situation isn’t quite as simple. That’s because you must consider the mix of taxable and nontaxable money in all your non-Roth IRA accounts in figuring the conversion tax, even if you’re converting all or some of just one of your IRA accounts.

Here’s an example. Let’s assume it’s 2010 and you have three IRAs: a traditional deductible IRA with a $20,000 balance that consists of $10,000 in deductible IRA contributions and $10,000 in investment earnings; an IRA rollover from an old 401(k) with a $24,900 balance that includes $10,000 in pre-tax contributions, $5,000 in after-tax contributions and $9,900 in investment earnings; and, a nondeductible IRA you opened in 2010 that has a $5,100 balance, your original $5,000 contribution, plus $100 in earnings.

You might figure you could hold down the conversion tax by converting just the $5,100 nondeductible IRA to a Roth, since only $100 of that account is taxable. Or you might think you could avoid conversion tax altogether by converting only your $5,000 nondeductible contribution, since that’s not taxable at all.

But this sort of cherry-picking won’t fly. Instead, you’ve got to total all your IRA balances (which in this case add up to $50,000) and then see how much of that amount is taxable and not taxable.

In this example, $40,000 is taxable (the $10,000 in deductible contributions to your traditional IRA, the $10,000 in pre-tax contributions to your 401(k), plus the $20,000 in combined investment earnings in all three accounts). And $10,000 isn’t taxable (the $5,000 in after-tax contributions to the 401(k) that are now in the IRA rollover, plus your $5,000 nondeductible IRA contribution).

That means that 80% ($40,000 of $50,000) of all your non-Roth IRA balances are taxable and 20% aren’t ($10,000 of $50,000).

It also means no matter how much IRA money you decide to convert and regardless of which account you pull it from, you must apply those percentages to the amount you’re converting.

So, for example, if you decide just to convert the $5,100 in your nondeductible IRA, you would be taxed on 80% of that amount, or $4,080. The same goes if you pulled just $5,000 from that account. Even though in your eyes you may see it as converting your $5,000 nondeductible (and nontaxable) contribution, in the IRS’s eyes, that $5,000 consists of the same blend of taxable and nontaxable money that exists in all your non-Roth IRAs. So you would owe tax on 80% of that five grand, or $4,000.

Tax diversify

One more thing. You say you can afford to contribute to both a Roth IRA and a taxable account. Given that you plan to retire early around age 50, I think funding both is a good idea. You can withdraw regular annual contributions to a Roth at any time without tax or the penalties that apply to withdrawals before age 59 1/2. But the withdrawal rules that apply to funds you converted and to earnings in your account are more complicated.

So to give yourself more maneuvering room when you’re ready to start living on your savings before age 59 1/2, it’s a good idea to have some dough in taxable accounts that you can tap without penalty. (I also think it’s a good idea to have money in tax-deferred accounts like a 401(k) or traditional IRA as well as taxable accounts so you can diversify your tax exposure in retirement.

The bottom line is that, thanks to the new rules that will start in 2010, exceeding the income limits for making an annual contribution won’t keep you from funding a Roth IRA. As long as you’re willing to follow the little strategy I’ve outlined here, you can still get money into a Roth IRA, regardless of how much you earn.