With some bit of fanfare, 2010 began a new era in regard to Roth IRAs for high income earners. While those single income tax filers earning more than $122,000 and couples earning more than $179,000 are still not eligible to contribute to a Roth IRA, anyone is eligible to convert existing Traditional IRA dollars into a Roth IRA.
While this opportunity was rolled out last year to great media attention, the conversion opportunity continues, albeit without the ability to spread the tax liability incurred from the conversion over two years. While this may not seem like a big deal, in effect it allows high income earners to actually fund a Roth IRA in 2011. Here’s how it can work:
Anybody with earned income, at any level, can contribute to a Traditional IRA. So a high income earner, while not allowed to contribute to a Roth IRA, can contribute to a Traditional IRA, then immediately convert it to a Roth IRA, potentially tax-free. This allows a high income earner to access the Roth IRA’s key benefit of tax-free growth.
So will everyone earning boo koo bucks plan on engaging this strategy in 2011? Probably not. While it appears yet another boon to the rich (and—gasp– during the Obama administration), there is a catch: Taxes on conversions are on a pro-rata basis. Let me explain by providing an example.
Joe has a Traditional, deductible IRA worth $300,000. In 2011, because he is a high income earner, Joe is only allowed to fund a non-deductible IRA for $5,000. His intent is to convert that $5,000 to a Roth IRA, thereby using the newly allowed back door Roth rules. On the surface, it would appear to be a great strategy.
However, the IRS says Joe must take into consideration his $300,000 IRA. So if he chooses to convert $5,000, which is less than 2% of his total IRA balance, he would only avoid taxes on less than 2% of the converted amount—a savings of a measly $29 in income taxes at a 35% rate.
In this situation, I’d likely advise Joe to simply purchase a stock or tax-efficient ETF rather than fund an IRA. Those investments get preferential future capital gains treatment, as opposed to ordinary income tax rates levied from a future IRA distribution. A discussion with Joe’s tax advisor and investment advisor is surely warranted, if he is considering a “back door” Roth IRA.