An individual who is an active participant in a qualified retirement plan cannot make deductible contributions to a traditional IRA unless her modified adjusted gross income is below certain specified levels.The level depends on the type of income tax return the individual files. For single taxpayers and heads of household, the otherwise allowable deduction is phased out ratably in 2006 and later years, when the taxpayer's MAGI is between $50,000 and $60,000.
For married taxpayers who file joint returns, it is phased out ratably when MAGI is between $75,000 and $85,000 in 2006, and between $80,000 and $100,000 in 2007 and later years. For married taxpayers filing separate returns, it is phased out ratably when MAGI is between $0 and $10,000.
The amount that an individual can contribute to a Roth IRA is also limited based on the individual's modified adjusted gross income. The allowable contribution phases out ratably between $150,000 and $160,000 for married taxpayers filing joint returns, between $95,000 and $110,000 for single taxpayers and heads of household, and between $0 and $10,000 for married taxpayers filing separate returns.
These phase-out rules (which are not inflation-indexed) apply regardless of whether an individual is an active participant in a qualified retirement plan.
However, an individual who has earnings from employment or self-employment income, and who is not eligible to make deductible contributions to a traditional IRA or contributions to a Roth IRA, is still able to make nondeductible contributions to a traditional IRA before the year that he attains the age of 70-1/2.
The chief advantage of making nondeductible contributions to a traditional IRA is that tax is deferred on earnings on those contributions until distributions from the IRA are made.
However, when earnings are distributed from a traditional IRA, those earnings are taxed at ordinary income rates. This is so even if the earnings consist in whole or in part of items such as long-term capital gains and qualified dividends that otherwise would be taxed at lower rates.
For some individuals, the disadvantage of losing favorable tax rates on qualified dividends and long-term capital gains may outweigh the benefits of tax deferral. This is especially so if the IRA owner is only a couple of years away from retirement. On the other hand, the advantage of tax deferral still remains if the assets of the IRA are invested in interest-paying securities or mutual funds that pay mostly nonqualified dividends.
For taxable years beginning before 2010, all or part of the amounts in a traditional IRA can be rolled over to, or converted into, a Roth IRA if the traditional IRA's owner's modified AGI in the taxable year of the rollover or conversion is not more than $100,000. A married individual filing a separate return could not convert a traditional IRA to a Roth IRA regardless of the amount of her MAGI for the taxable year that the separate return was filed, unless that individual lived apart from her spouse for the entire taxable year.
Any amount that is rolled over or converted is treated as a distribution to the owner, and is includible in the owner's gross income to the same extent that it would have been included if the distribution had not been rolled over or converted. In determining whether the traditional IRA owner is eligible to roll over or convert all or part of the amount in a traditional IRA to a Roth IRA, MAGI for the taxable year does not include any amount includible in gross income because of the rollover.
The tax costs of rolling over assets from a traditional IRA to a Roth IRA often outweigh the benefits of making that rollover. However, a rollover could be useful in some cases if the owner is in a low tax bracket, but still doesn't need to take distributions from his IRA. Another situation where it probably would be beneficial to make the rollover is where most of the value of the traditional IRA consists of nondeductible contributions previously made to it.
In some cases, it may be possible for the owner of a traditional IRA to roll over all of the deductible contributions and earnings in that IRA to a qualified plan, and leave only nondeductible contributions in the traditional IRA. He would then, if otherwise eligible, be able to roll over the nondeductible contributions remaining in the traditional IRA to a Roth IRA.
For taxable years beginning after 2009, the Tax Increase Prevention and Reconciliation Act of 2005 eliminates the $100,000 MAGI limit on conversions of traditional IRAs to Roth IRAs, and also permits married taxpayers filing a separate return to convert amounts in a traditional IRA into a Roth IRA. Thus, taxpayers may make such conversions regardless of the amount of their MAGI for the taxable year in which the conversion is made.
IRA-to-Roth-IRA conversions occurring after 2009 are subject to the same income inclusion rules that apply under pre-TIPRA law (that is, the income resulting from the conversion is included on the return for the taxable year in which funds are transferred or withdrawn from the IRA).
For conversions occurring in 2010, however, none of the gross income from the conversion is includible in income in 2010, unless the taxpayer elects to have it included in that year. Instead, 50 percent of the income resulting from the conversion is includible in gross income in 2011 and the other 50 percent is includible in 2012.
Example 1: Your client has a balance of $30,000 in her traditional IRA in 2010. The balance consists of $18,000 of nondeductible contributions and $12,000 of earnings. If she converts her traditional IRA to a Roth IRA in 2010, none of the earnings in the traditional IRA will be includible in her gross income in 2010, but $6,000 will be includible in 2011, and $6,000 will be includible in 2012, unless she elects to have the earnings includible in 2010.
Recommendation: Many individuals who are ineligible to contribute to a Roth IRA, and who are also ineligible to make deductible contributions to a traditional IRA, have not been making nondeductible contributions to a traditional IRA because they did not believe that the tax benefits would be worthwhile to them.
However, they would contribute to a Roth IRA if eligible to do so, since they would then be able to take earnings out of the Roth IRA tax-free, or be able to avoid the required minimum distribution rules that apply to traditional IRAs but not to Roth IRAs.
Now, such an individual should consider making nondeductible contributions to a traditional IRA and then converting the traditional IRA to a Roth IRA after 2009. If he doesn't take any distributions from the Roth IRA until after age 59-1/2, and until after the fifth year the Roth IRA was in existence, distributions of earnings from the Roth IRA will be tax-free. While earnings received during the time before the conversion will be includible in gross income in the taxable year of the conversion (or half will be includible in 2011 and half will be includible in 2012, if the conversion takes place in 2010), most of the amount converted will probably consist of nondeductible contributions.
Example 2: Your client, who was 50 years old on March 15, 2006, is not eligible to contribute to a Roth IRA or to make deductible contributions to a traditional IRA. Before 2006, he has never made nondeductible contributions to a traditional IRA.
He is eligible to make nondeductible contributions of $5,000 (including catch-up contributions) to a traditional IRA in 2006 and 2007, and of $6,000 in 2008, 2009 and 2010. If your client contributes the maximum amount for each year from 2006 through 2010, his total nondeductible contributions will amount to $28,000.
Assume he earns a total of $8,000 on those contributions, and then converts his traditional IRA to a Roth IRA after making his 2010 contribution to the traditional IRA. He will then have $36,000 in a Roth IRA. He will have to include $4,000 of the amount converted in his gross income in 2011, and $4,000 in 2012.
Any additional earnings after the traditional IRA is converted to a Roth IRA will be distributable to your client tax free if he doesn't take any distributions from the Roth IRA before he reaches age 59-1/2 on Sept. 15, 2015.
Recommendation: A traditional IRA should be converted to a Roth IRA as soon as possible in 2010, so as to minimize the amount of earnings that will be taxable on the conversion. If the contribution for 2010 cannot be made until later in that year (or until 2011), then make the conversion early in the year, and then roll over the amount contributed to the traditional IRA for 2010 immediately after the contribution is made.
Observation: TIPRA did not make any changes in the rules for making direct contributions to a Roth IRA, i.e., the MAGI limitations on making those contributions still exist. However, apparently you can get around those limitations after 2009 by first making nondeductible contributions to a traditional IRA, and then converting the traditional IRA to a Roth IRA or rolling over the amount in the traditional IRA to a Roth IRA.
In effect, this seems to make the MAGI limits on making contributions to a Roth IRA after 2009 meaningless.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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