New Roth IRA rules this year invite high income earners to join the tax-free party. For them, it’s an income and estate planning opportunity nonpareil. If you have the wherewithal and will to let your Roth span generations, it could help you turn $120,000 into over $5 million with no taxes or penalties.
Roth contributions are not deductible, but the beauty emerges over time. Owners of traditional IRAs must take minimum taxable distributions starting at age 70. With Roths, you are not forced to take distributions and they are not taxed as long as you comply with the rules — no matter how much the account has grown in value.
So why is this news? After all Roths have been available for more than a decade. Before this year, they have been strictly a middle- to low-income earner opportunity. In order to maximize your Roth contribution, your family income must be below $167,000 while singles can only have an income of $105,000. There were income limits on Roth conversions as well.
Starting this year, high-income earners now have a path, albeit convoluted, to make Roth contributions. The first step is making a non-deductible traditional IRA contribution. Most of us can make a traditional IRA contribution, but participation in a work retirement plan usually prevents it from being deductible. When you make a non-deductible IRA contribution, you don’t take the deduction but instead track your basis on IRS Form 8606 every year.
When converting an IRA to a Roth, you don’t pay income tax on your original basis — the non-deductible portion of your contribution. If you are 50 or over and still working, you and your spouse could contribute $6,000 each in non-deductible IRAs. Once this account is funded, you can next convert those IRAs into Roths. If those are your only traditional IRAs, then you would owe little or no tax as long as you converted it soon after funding it with after-tax dollars.
Of course there are often gotchas that can foul up the most deliberate tax strategy, and this one is no exception. The challenge is when you have IRA, SEP-IRA, or SIMPLE-IRA balances in other accounts. The IRS does not let you convert just the non-deductible portion. You must consider all IRA balances at the end of the year of the Roth conversion in what some planners call the “coffee in the cream” rule. A big percentage of the conversion could be taxable.
One way around this is to roll your existing deductible traditional IRAs into a retirement plan, including a solo 401(k) plan for those who own a small business. The rule does not consider 401(k), 403(b) and other retirement plan balances. By concentrating your pre-tax balances in those accounts, you can minimize paying tax when converting your IRA.
So a Roth may be great, but is it worth all of this work? Consider a couple aged 55 with a 20-year-old child contributing $12,000 a year to a Roth IRA for ten years. They let it grow for 25 more years until the child inherits the account. Only when the Roth has been inherited do minimum distributions begin. Assuming average annual returns of 8 percent, the child would receive more than $5 million tax-free. This is all from a $120,000 initial contribution.
Please seek help from a professional if you embark upon this strategy. The timing of the funding and conversion of traditional IRAs are critical, as is the method of segregating non-deductible traditional IRA balances. The deadline for Roth conversions is the end of the year, so you should get started soon to get this done for 2010.
Dave Gardner, for the Daily Camera.