Waiting to Roth: Hidden Loophole for High-income Earners
IRAs, 401(k) plans, and other retirement plans are an increasing share of the assets of a typical American. With traditional IRAs and 401(k)s, you make pre-tax contributions and the earnings are tax-deferred. Withdrawals are taxable and must be made beginning age 70 ½. In addition, with a few exceptions, withdrawals prior to age 59 ½ are subject to penalties.
There are different “Roth” versions of both these plans. The Roth IRA came into existence in 1998 while the Roth 401(k) came into existence in 2006. Originally, the Roth 401(k) was set to expire in 2010, but in late 2006 Congress removed the expiration provisions on the Roth 401(k).
With Roth plans, the contributions are made with after-tax money, but the earnings and withdrawals are tax-free. This makes the Roth quite attractive to many people, especially high-income earners. Unfortunately, many people are not eligible to make contributions. Individuals making over $110,000 (2007) and married couples making over $160,000 (2007) cannot make a Roth IRA contribution. While even those earning above those limits could make a contribution to a Roth 401(k), few employers have amended their plans to allow Roth 401(k) contributions yet.
Those wishing to convert their IRA from a regular IRA to a Roth IRA must not have income over $100,000. However, in 2010, the income limit for conversion to a Roth IRA is lifted, even while the limit for contributions remains. But, this opens a loophole. Even those who cannot contribute to a Roth IRA or a deductible regular IRA can open a non-deductible regular IRA, as long as they have employment income. The limit in 2007 is $4,000 and in 2008 and beyond is $5,000. In addition, for those over 50, the limits are $1,000 higher. So, in 2007 through 2010, you could contribute as much as $23,000 to a non-deductible regular IRA. Then, in 2010, regardless of your income, you could convert the non-deductible IRA to a Roth IRA.
If you convert a regular, deductible IRA, you would need to pay income tax on the entire IRA upon conversion. However, since you never took a deduction for the contribution to the non-deductible IRA, you would only pay tax on the growth between the date of contribution and the date of conversion. After that, neither you nor your heirs would ever pay a penny in income tax on it. And, it gets even better, because with a Roth IRA, you never have to take withdrawals during your lifetime.
IRAs, 401(k)s, and other retirement plans can be quite complicated. However, an attorney knowledgeable in estate and retirement planning can help you navigate the minefield and take advantage of hidden loopholes, like, for those with income too high to contribute to a Roth IRA, contributing to a non-deductible IRA and converting to a Roth in 2010.