Although the income restriction for converting Traditional IRA assets to a Roth were lifted in 2010, there are still limits in place with regard to Roth IRA contributions:
Roth IRA contribution eligibility (2011)
Individuals: Income must be less than $122,000 (full contribution available below $107,000, partial contribution available between $107,000 and $122,000)
Joint filers: Income must be less than $179,000 (Full contribution available below $169,000, partial contribution available between $169,000 and $179,000)
Since anyone, regardless of income, can make a non-deductible (i.e., “after-tax”) contribution to an IRA, does this present an opportunity to effectively circumvent the Roth IRA contribution rules?
Let’s consider an example where “Bob” is a single taxpayer and wishes to contribute $5,000 into a Roth IRA, but his income is higher than the amount referenced above. Bob could make a non-deductible IRA contribution of $5,000 and then immediately convert those assets to a Roth IRA — there would be no taxes due on the Roth IRA conversion since those funds had previously been taxed. It’s important to note that the effectiveness of this option depends on where Bob may hold other retirement savings.
Scenario 1: Bob has retirement savings within his employer’s 401(k) plan, but does not own any other IRAs.
In this case, the strategy of making a non-deductible IRA contribution and immediately converting it to a Roth can be effective. Since the $5,000 contribution is made with after-tax funds, there is no tax liability on converting those funds to a Roth IRA. In this case, Bob has effectively funded a Roth IRA with the annual $5,000 contribution limit.
Scenario 2: Bob owns a Traditional IRA (consisting entirely of pretax funds) valued at $20,000.
In this case, the tax calculation when Bob converts his $5,000 non-deductible IRA contribution to a Roth becomes more complicated. When figuring taxes upon conversion, non-deductible IRA assets (i.e., “after tax”) cannot be segregated from pretax IRA assets.
All IRA assets (including SEP and SIMPLE) must be aggregated and converted on a pro-rata basis depending on the percentage of after-tax IRA assets to pretax IRA assets. This is often referred to as the aggregation rule.
Here’s how the tax calculation would work when Bob converts the $5,000 non-deductible IRA contribution to a Roth.
Step 1: Aggregate all IRA assets:
$20,000 Traditional IRA (pretax) + $5,000 non-deductible contribution (after-tax) = $25,000 in total IRA assets
Step 2: Determine the percentage of non-deductible assets to the total IRA assets:
$5,000 non-deductible IRA contribution divided by $25,000 total IRA balance = 20%
Step 3: Apply that percentage on the amount of assets converted to determine the non-taxed amount upon Roth conversion:
20% of $5,000 contribution being converted = $1,000
End result of converting $5,000 to a Roth IRA*:
- $1,000 is non-taxable
- $4,000 is taxable
* Note that after the conversion, the remaining balance of $20,000 in the Traditional IRA would consist of $16,000 in pretax funds and $4,000 in after-tax funds.
Determining the tax liability on Roth conversions can be very complicated if you hold IRA assets in different accounts. Talk to a financial advisor or tax professional before moving forward to make sure you are taking full advantage of the benefits a Roth IRA conversion may hold for you.
Download our investor education piece, Converting a Traditional IRA to a Roth IRA for more information.