Volume 3 Issue 2007

The day may be dawning soon when you plan to convert your traditional IRA into a Roth IRA. The pot of gold at the end of the rainbow: Future distributions from the Roth will be 100% tax free. But you might be better off taking a different route to “the Promised Land.”

Strategy: Roll over funds from traditional IRAs to your company-retirement plan (assuming the plan permits
it). By doing so, you won’t be clobbered by a heavy tax bill if you convert to a Roth IRA down the road. Why? Because of a little-noticed wrinkle in the IRA tax rules.

Here’s the whole story: After the Roth IRA has been in existence for five years, qualified distributions are completely exempt from income tax if they are made after you attain age 59 1/2, on account of death or disability or to pay for the expenses incurred by a first-time homebuyer (up to a lifetime limit of $10,000).

In contrast, distributions from a traditional IRA may be fully taxable at ordinary-income rates reaching as high as 35%. So you have a tax incentive to convert a traditional IRA to a Roth, even though you’re hit with taxes when converting.

Note: The normal contribution limit for all IRAs (including Roth IRAs) for 2007 is $5,000; $6,000 if you’re age 50 or older. Those limits will be adjusted for inflation after 2008 in $500 increments. Those limits don’t apply to Roth conversions.

Currently, you can convert to a Roth IRA only in a year in which your AGI is less than $100,000. But a tax-law change in 2006 removed this income barrier for the tax years beginning after 2009. What’s more, you can spread out the resulting tax over two years—2011 and 2012—for a conversion taking place in 2010.

One popular idea: Set up a nondeductible IRA if you won’t benefit from deductible contributions to a traditional IRA. (Deductions are not available for high-income taxpayers if you participate in an employer-retirement plan.) With a nondeductible IRA, only the earnings are taxable when you take distributions. So, when 2010 rolls around, you can shift more funds into a Roth IRA without any such tax consequences.

Bump in the road: You can’t just take distributions from your nondeductible IRA. The IRS treats any distribution as coming on a pro rata basis from all of your IRAs. That could mean a much bigger conversion-tax bill than you expected (see box).

However, if you shift traditional IRA funds to your company plan before 2010, you can sidestep the brunt of the tax. Example: If you participate in a 401(k) where you work, you can roll over the full amount in your traditional IRAs without paying any current tax. That will leave you with just a nondeductible IRA.

Example: Suppose you contribute $6,000 to a nondeductible IRA each year for five years before you retire. The contributions earn 8% annually, so the account balance will be worth $38,016 after five years. If you close out all of your other IRAs, you only have to pay tax on the $8,016 of earnings ($38,016 minus $30,000 in contributions).

Similarly, you might have your spouse establish a nondeductible IRA, if he or she doesn’t have traditional IRAs stocked with tax-deductible contributions.

Of course, you still have to pay tax on your 401(k) contributions after you retire, but you’ll have some flexibility concerning the distributions. Also, it’s likely you will be in a lower tax bracket in retirement than you are while working full time.

Tip: Assuming you don’t need the money right away, leave the funds in your 401(k) for a few years. You don’t have to begin distributions until the year after you turn age 70 1/2.