As I last wrote, the ability to deposit money into a Roth IRA is phased out if you are single with a MAGI of $125,000, or married with a MAGI $183,000. However, all is not lost. The rules for conversion changed way back in 2010, and the income limit for a Roth conversion was eliminated. Prior to this change, an income of over $100,000 kept you from converting from a Traditional IRA to a Roth.
Above the Traditional IRA phaseout numbers, you are still permitted to make that IRA deposit, just not deduct it. It’s deposited as post-tax money. Now you are allowed to ‘convert’ this money to a Roth. Since you already paid the tax on these funds, the conversion should come with no tax bill at all. There’s no minimum about of time the money needs to sit in the IRA, you can make the deposit and hand over the form to convert. Thus, the two-step.
For those who already put in the maximum in their 401(k) or other employer based account, this is an opportunity to put a bit more money away, and to do it in a way that will save you taxes over the rest of your life.
For those whose 401(k) plan has high fees, you may be best off depositing up to the match, but not a dime more. This deposit-and-convert strategy gives you a great chance to put away another $5000 (or $6000 if 50 or older). These numbers apply to your spouse as well.
Last, when it comes to the IRA, you have only one Traditional IRA. Let’s ignore the inherited account for sake of simplicity. By this I mean that even though you have multiple accounts set up, perhaps with Schwab, Fidelity, etc, as far as the IRS is concerned, it’s one big (I hope) IRA. So if over the years, you’ve made deposits that you were able to deduct, you need to be careful with this strategy. If, for example, you have $45,000 in pre-tax IRA money, and deposit $5,000, any conversion would find 90% of the converted funds to be taxable at your marginal rate. So, convert $5,000, and it’s not tax free. $4500 gets taxed at your marginal rate. This strategy works great if you haven’t made any pretax IRA deposits, or if those deposits were minimal.
Next time, I’ll offer a way around this tax trap, and show you how to convert your post tax IRA money no matter what your history.