Non-Deductible IRA Contribution & Roth IRA Conversion Rules

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Mrs. MMB and I both contributed $5,000 each to a non-deductible Traditional IRA again for the 2012 tax year this week, with the intention of converting it into a Roth IRA in the future. Are you eligible to do this as well? Of course, we had to wade through a ton of IRS fine print to try and achieve a bit of tax savings.

First, can we just contribute directly to a Roth IRA? Per this IRS flowchart, because we are married filing jointly and will most likely have a modified adjusted gross income (MAGI) over $183,000, we are unable to contribute to a Roth IRA. How many people know what their MAGI is? It’s not impossible to figure out, but if I was closer I’d rather wait and have TurboTax figure it out for me when I filed my 2012 taxes.

Can I contribute to a Traditional IRA, even if I have a work retirement plan? Yes, it doesn’t matter if you have a 401k or 403b or whatever. The question is whether it is tax-deductible. Remember, when money is withdrawn from a Traditional IRA, it is taxed again at ordinary income rates.

Well, is the contribution tax-deductible? From this other IRS flowchart, because we are married filing jointly, covered by a retirement plan at work, and have an MAGI of over $112,000 or more, I see out that our contribution is not tax-deductible. Finally, you should remember to note the non-deductible (post-tax) contributions on IRS Form 8606 at tax time.

Can I convert my non-deductible IRA to a Roth IRA? In 2010, the previous $100,000 income limit for Roth IRA conversions was removed. It was initially thought to be a temporary thing, but it has not been addressed since. There is some speculation that the government is quietly (and happily) collecting taxes right now on all the rollover money, as opposed to later. Thus for 2012, there is again no income limit on the conversion from a Traditional IRA to Roth IRA. Even so, there are still some catches if you have both deductible and non-deductible (pre-tax vs. post-tax) IRA balances available to be converted. We have already converted all our pre-tax IRAs a while back, so it will be a simple “same trustee transfer” at Vanguard for us.

Okay, so we successfully navigated all these IRS rules and legally minimized our tax liability. But how many people won’t? Even for tax benefits for low to moderate-income earners like the Earned Income Tax Credit, the Government Accountability Office (GAO) found that between 15% and 25% of households who are entitled to the EITC do not claim their credit, or between 3.5 million and 7 million households. I mean, just look at how long the Wiki page that supposedly summarizes the credit is. It shouldn’t be this complicated.

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  1. Everyone knows tax code is complicated, that’s why tax accountants and CPA’s make tons of money going through it and finding suitable things for their client. I am sure many agree we need a better and simplified tax code but when we will get their is million dollar question.

    Jonathan as you pointed out, IRA is just a small piece of IRS puzzle. The rules you mentioned are certainly small subset of big flowchart and are really complicated with if’s and buts. I am self employed and don’t have SEP or any other plan but I like to start some day. For now, I just simply contribute to deductible IRA to take tax deduction for now and making my life little easier.

  2. I read this twice, but don’t have a good enough understanding of IRAs to understand the benefit of the process you described. It appears that your contribution was not tax deductible, but you “legally minimized [your] tax liability”. Is this because later converting to a Roth IRA will make the withdrawals tax free? But there would be no immediate reduction in taxable income? My financial picture is similar this year, so this is helpful.

  3. Jonathon, Ever since I noticed this Roth IRA conversion option was available (and even before when the Roth was first introduced) I suspected it was just a scheme for the politicians to get those tax dollars now…to spend now, without any consideration for the consequences decades from now when those politicians will probably be long gone or out of the picture.

    I think it is just another way for them to stick it to the next generation(s) (our children and grand children) without regard to the future of our country or solvency.

    That withstanding, it does seem like a good option for many investors.

  4. I like that you reference higher income phase outs – 90% of articles about IRA investing parrot “wisdom” of always going Roth IRA first…and never mention that higher incomes can’t take advantage of that.

  5. Odd that there seems to remain a loophole to contribute and immediately convert to a Roth. But as long as the loophole remains open it’s a great way to save some extra cash from retirement and balance the tax treatment of 401(k)s and the like. Great step-by-step!

  6. I’ve been converting all of my IRA money over to Roths as well. To my mind, that is the best vehicle available. As I have a mix of tax-free (Roth), tax-deferred (employee plan), and taxable savings/investments, I think having the most possible in the Roth category is a good strategy.

    There are no required minimum distributions from a Roth IRA, which means one can leave the money in the account to compound tax-free as long as possible. In retirement I will plan to draw down the Roth last so if we have an estate the Roths will be passed on to my heirs. Then they will be able to take only minimum distributions based on their expected lifetime, which ideally will allow the money to continue to grow tax deferred for many more years. Also, they will not have any tax burden associated with the gains, which should be very substantial over the decades, which is nice.

  7. I think a bigger question to ask here is if you have a combination of deductible & non-deductible IRA contributions then would you consider converting your non-deductible IRA to a Roth IRA. Should you be paying additional tax $$ on the traditional/rollover (deductible) contributions etc from the past years.

    Some experts have recommended to rollover your deductible contributions to a 401K plan of your existing employer as a work around.

    I am in a similar MAGI situation as you are. However, I do have a combination of deductible as well as non-deductible IRAs. What are your thoughts on that?

  8. NS – I’m not sure what you are asking, but I do know if you have a combination of deductible and non-deductible IRAs, and convert some portion of them, the IRS considers the amount converted to be a mix of the two, in proportion to what your total IRA balance is. So even though you are converting one of your IRAs that was a non-deductible contribution, they consider part of that to be your deductible one, and you have to pay the taxes on it.

  9. All I have to say is… would eliminate all of this sillyness.

  10. @Michael S – Yes, basically I am contributing to a Roth IRA, just indirectly. Like a Roth IRA, my contribution is *not* tax-deductible, but future earnings and withdrawals are tax-free. If I had just kept it in the non-deductible IRA, I wouldn’t have to pay taxes while the earning accumulate, but I would have to pay taxes upon withdrawal.

    @Jack – I agree, it’s just another case of “give me the money now, I’ll worry about the rest later”.

    @Andy – Good points about no required minimum distributions. For those that want to leave an estate, Roth IRA is also a good estate planning tool as you can leave them as an inheritance – and it keeps going tax-free!

  11. @Jack – In the long run, we’re all dead…

  12. @NS – Yes, having pre-tax money kept in an employer 401k as opposed to IRA is a way to shield the pre-tax money from being pro-rated (taxed by proportion) upon Roth IRA conversion.

    It depends on the size of your pre-tax IRA and your tax rate. If you really don’t want to pay your taxes now on the pre-tax money and just convert it all to Roth, *and* you are okay with your 401k plan, then you may want to roll it over first to a 401k first, then convert your non-deductible IRAs. Yet another trick to employ, but as usual do your research.

  13. Question – I have deductible and non deductible IRAs. However, I have them in separate accounts. So if I convert my nondeductible IRA to a ROTH IRA, would the IRS still consider what’s converted a mix of the 2 types?

    Seems like since I do not have the funds commingled, I should be able to get full credit for converting only the nondeductible IRA amount.

  14. @Melissa – It doesn’t matter if they are in separate accounts or with different trustees. All IRAs are considered together. If you had a $10k non-deductible IRA at Fidelity and a $10k deductible IRA at E-Trade, any $10k distribution to a Roth from either account would be considered 50/50 from each kind. That’s how all the reputable sources interpret the IRS docs.

  15. Ed Slott is probably the best writer out there to explain the ins and out of ira’s. His web site is informative, especially under the link at the top of the page called, IRA Resources.

  16. Ed Slott also had an 8-part (!) series on Roth IRA conversion in the NY Times back in 2010:

  17. What are your thoughts on this article?

    It seems like doing the strategy that you describe (contribute to non-deductible traditional IRA and then convert to Roth IRA), can be viewed as a “step transaction” which basically means that you contributed to a Roth IRA and weren’t supposed to, and could be penalized.

    I want to try this out, but I don’t want it to backfire down the line on me…

  18. @Double A – I’ve read the article, and in my opinion it is much ado about nothing. First, this option has been available since 2010, there has been coverage in all the major financial media, and the IRS hasn’t said a thing. Congress could have put a limit on such IRA rollovers easily at any time, and they didn’t. It’s not like we’re moving money to the Cayman islands here.

    Second, the previously-mentioned expert Ed Slott has also addressed this issue and says that even in the unlikely chance that it does apply, just let your non-deductible contribution sit there for a few days or long enough to show up on one statement, and you’ll be fine.

  19. Kevin Clancy says

    Mr and Mrs MMB:

    I understand most of the rules around contributing to a non-deductible IRA and transferring to a Roth. What I am not clear on is the time that balances may need to remain in the Traditional IRA. For instance, if I contribute $5K to a non-deductible traditional IRA on April 1st, 2012 as a 2011 contribution can I convert it to a Roth any time going forward as a 2012 contribution? Obviously this quick convert would potentially decrease any profits upon conversion. Your knowledge is appreciated in advance!


  20. Michael Y says

    If I only have a nondeductible IRA and a workplace 401K, and I convert the nondeductible IRA to a Roth, is my workplace 401K balance considered in the calculation of the taxes that I have do pay? My question is: is my workplace 401K treated like a deductible IRA when calculating taxes for the nondeductible IRA conversion to a Roth IRA?

    Thank you

  21. The nice thing about a Roth IRA is that you will not have to face Required Minimum Distributions later, unlike with traditional IRAs. Once you reach the age of retirement, not having to worry about paying tax on withdrawals can make your life much less stressful. Also, anything left to your heirs goes to them tax-free, rather than being taxed in their top bracket.

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