As we’ve seen, after you reach a certain income, both Roth IRAs and tax-deductible contributions to Traditional IRAs are no longer available. After you max out your 401(k) or 403(b) plan at $15,500 per year, you start running out of tax-advantaged accounts quickly. One option is to contribute to a Traditional IRA anyways, even though the contribution will not be tax-deductible. Everything else is the same: your money will still grow tax-free, and withdrawals will be taxed at your ordinary income tax rate. You can sock away $4,000 for 2007 and $5,000 for 2008. So should you do it? I have less than three weeks before I need to decide!
There appear to be two primary ways to answer this question:
- Future Roth Rollover. In 2010, there will no longer be any income restrictions for Traditional-to-Roth IRA rollovers. Could this mean Roth IRAs for everyone?
- Compare Returns vs. Taxable Account. If you either can’t or don’t wish to convert to a Roth, will your performance at least be better than a regular taxable account?
Future Roth IRA Rollover
According to current laws, in 2010 the income restriction for Traditional-to-Roth IRA rollover will disappear. Since you’ve already paid taxes on your non-deductible IRA contributions, you will only have to pay income tax on the earning portion when you rollover. This can be seen as effectively allowing you a way to contribute to a Roth IRA down the road. Now, instead of having to pay ordinary taxes upon withdrawal, I don’t have to pay any taxes! I even avoid required minimum distributions.
Catch #1: The Law May Change
I have seen no indication that this Roth “back door” was intentional. Some people see this as simply an oversight that a busy (or lazy) Congress simply hasn’t gotten around to changing… yet. For example, the current low 15% long-term capital gains rate is also scheduled to go up in 2011. Others think that the lure of tax revenue now gained through Roth conversions might be appealing and they’ll let it stay. Now I’ve waited until the last minute to make my decision and it’s almost mid-2008, and nothing has changed, so maybe it’ll happen…
Catch #2: Mixing Deductible and Non-Deductible Contributions
Let’s say you have $10,000 in a Traditional IRA, $4,000 of which was a non-deductible contribution, and $6,000 of which was deductible contributions and earnings within the IRA. If you wanted to convert $4,000 of it over to a Roth IRA, you can’t simply pick out the non-deductible contribution. The $4,000 would be pro-rated to be 40% non-taxable and 60% taxable, in the same proportions as your total IRA.
The only way to convert all of your non-deductible contributions would be to convert everything together, which might not be ideal.
One way around this is to first roll over your deductible IRA money into another qualified retirement plan like your 401(k) if they allow such transfers (and you like your investment options). Then make your non-deductible IRA contribution. That way, the deductible and non-deductible parts can be separated. I don’t have any deductible IRA funds, but I think I could rollover into my Solo 401(k) if desired.
Catch #3: More Paperwork
If you make non-deductible contributions, conversions, or withdrawals you must document them each year using with IRS Form 8606. It’s probably a good idea to simply file the form every year so that you don’t end up forgetting and having to pay extra taxes later.
In general, I think the Roth conversion option is great if it’s available, but I am still not convinced it will still be around in 2010. So I’d better make sure that’s a non-deductible IRA is still a decent deal even without that option. To be continued in Part 2…