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How to Sidestep the Roth Contribution Limit

Here's an answer to a frequently asked question.

Natalie Choate, 03/12/2010

Top estate planning and investment professionals rely on Natalie Choate's best-selling book Life and Death Planning for Retirement Benefits, often called the "bible" of retirement benefit distribution planning, for everything they need to know about the rules governing their clients' retirement plans and IRAs. Order Natalie's book for $89.95 plus shipping by calling 800-247-6553, or online at www.ataxplan.com.

I get lots of Roth IRA questions these days, but this is the one I get the most-about once a day! I'm hoping this column will head off this question at least for the next month.

Question: If a high-income taxpayer makes a nondeductible IRA contribution, is he free to convert it to a Roth IRA immediately? Or would this be deemed an excess Roth conversion if done in the same year?

Natalie: He is free to convert it immediately. It would not be deemed an excess Roth IRA contribution. There's no legally required waiting period; however, it would make sense to wait until you have received adequate documentation that the original contribution was made to a traditional IRA, just so the record is absolutely clear.

For some reason, Congress left income limits in place for making "regular" (annual-type) contributions to a Roth IRA, even though they removed the income limit for conversion contributions. So this sequence (contribute to a traditional IRA, then immediately convert the account to a Roth) will be very popular with everyone who (1) wants to make a regular contribution to a Roth IRA but is ineligible to do so and (2) is eligible to contribute to a traditional IRA. To be eligible to make a regular contribution to a traditional IRA you must have compensation income at least equal to the contributed amount and be younger than age 70½ as of the end of the contribution year.

As a reminder, the fact that the participant is converting a newly-created IRA (funded with a nondeductible contribution) does not mean that the conversion is automatically "tax-free." The conversion of a newly-created traditional IRA is taxed just like the conversion of any other traditional IRA; you do not look only at the pre- and after-tax money in the particular account he happens to be converting.

The nontaxable portion of any IRA conversion (whether of a brand new account or an IRA you've held for years) is determined the same way. You multiply the converted amount by a fraction. The numerator of the fraction is the total amount of after-tax money the participant has in all of his traditional IRAs. The denominator is the total combined value of all of the participant's IRAs. The amount that results from applying this fraction is the only amount that you can treat as the tax-free conversion of after-tax funds-regardless of which account the conversion actually came from.

Example: Fred and Ed each make nondeductible $5,000 contributions to their respective newly created traditional IRAs on Monday, March 1, 2010. A week later, each of them converts his newly created $5,000 traditional IRA to a Roth IRA. Even though they both followed exactly the same steps, they have very different tax results.

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