Want to convert IRA? Here's a plan
By Jonathan Clements
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It's a tortuous journey — with a happy ending.
Yes, you should make a 2006 contribution to an individual retirement account by the April 17 tax-filing deadline, even if you don't qualify for the tax deduction. But if your goal is to convert the account to a Roth IRA in 2010, when high-income earners become eligible, you could be in for a nasty surprise. There's a little-known problem with the strategy — but also two little-publicized solutions.
Both accounts can be a great investment. But unfortunately, you won't qualify for either if you're covered by a retirement plan at work and your total income for the 2006 tax year is above $110,000 if you are single, or above $160,000 if you are married filing jointly.
That still leaves the nondeductible IRA, which has emerged as an intriguing alternative. Before the May 2006 tax law, you could convert a regular IRA to a Roth only if your total income was below $100,000. But last year's tax law removed that income criterion starting in 2010 — and suddenly nondeductible IRAs became a hot ticket.
The strategy: Make nondeductible IRA contributions, which in 2006 and 2007 are capped at $4,000 or, if you are age 50 or older, at $5,000. Then, in 2010, convert the whole account to a Roth.
Imagine that, at that point, the account was worth $25,000, of which $20,000 was nondeductible contributions. When you convert, you would owe income taxes on the account's $5,000 in investment gains. In return for that modest tax hit, your new Roth IRA would grow tax-free thereafter.
Pretty sweet? It is — provided you don't have other IRAs. But suppose that, as of 2010, you also have $100,000 in a regular IRA. You couldn't convert just the $25,000 nondeductible account, says James Lange, author of "Retire Secure."
Rather, you have to assume the $25,000 conversion is coming pro rata from your $125,000 total IRA. Result: You would owe taxes on $21,000 because, in this example, the pro-rata share of your nondeductible contributions would be just $4,000.
Second, even if you have a large IRA, your spouse may not. That means your spouse could fund a nondeductible IRA between now and 2010 and then convert his or her account, says Cincinnati financial planner David Foster.
What if neither solution is an option? What if Congress takes away the 2010 conversion opportunity? Making nondeductible contributions can still make sense. "It's a little bit of administrative work," Lange concedes. "Other than that, I don't see any downside."
Without the chance to convert in 2010, a nondeductible IRA might seem unappealing because eventually your withdrawals would be taxed at federal income-tax rates as high as 35 percent. By contrast, if you invest in a taxable account, you can take advantage of today's low tax rate on long-term capital gains and qualifying dividends, which currently tops out at 15 percent.
But the IRA is still a fine savings vehicle if you plan to buy bonds, real-estate investment trusts and actively managed stock funds. After all, part or all of your gain from these investments will be taxed as ordinary income anyway — and the IRA allows you to defer those taxes.
Moreover, if you can't convert in 2010, you may get an opportunity when you retire. One tax-smart strategy: Leave your 401(k) balance with your old employer for a few years and use that time to convert your IRA, including your nondeductible contributions, to a Roth. Because you no longer have a paycheck, you should be in a low tax bracket — and the cost of converting ought to be pretty modest.
