Roth IRA's - A Simple Strategy to Work Around the AGI Limits

In 2010, the rules changed for Roth IRAs (see previous post) where now anyone with a Traditional IRA may convert a portion or all to a Roth regardless of their Adjusted Gross Income. This is all good and fine for those of us who have Traditional IRAs to convert, but what about the rest of us who just have their company 401(k)s and make too much money to contribute to a Roth?

Well, there's a little known aspect about Traditional IRA contributions in that ANYONE can make them, regardless of their income level provided they have earned income equal to or higher than the contributed amount. Your income level only determines the deductibility of the contributions for the year that those contributions were applied to, not whether or not you can contribute at all.

Thus, an individual who is not eligible to contribute to a Roth can still contribute to a Traditional IRA, albeit a nondeductible one. The individual can then immediately convert their contributed amount to a Roth IRA. There are certain basis rules that apply if you have other Traditional IRA balances that could make all or part of the conversion taxable, but if you have those you probably would not do this until you had fully converted the other balances first.

Strategy in Action - An example:

Joe makes too much money to contribute to a Roth, but still wants to save after tax dollars for retirement. He has no traditional IRAs, but does have a 401(k) at work. To accomplish his goal, Joe could open a traditional IRA and contribute the maximum allowed amount, and then direct his trustee to convert the balance the following day to a Roth IRA. Thus, Joe now has a Roth IRA via the conversion rule now allowed even though he doesn't qualify to contribute to a Roth.

This may seem like a lot of hoops to jump through but administratively it is not too difficult and the tax savings are plentiful. If you are up to the task, your retirement could be all the richer for investing in a Roth!