The Roth IRA Two-Step

by Joe on May 8, 2012

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.

{ 4 comments… read them below or add one }

Honolulu Aunty May 8, 2012 at 3:59 pm

Whoa Joe!!!

So I can contribute $6000 (I am old enough) to a regular IRA even if our AGI exceeds the deductible limits for contribution purposes – we just don’t get to write it off on our income tax return? And THEN I can convert to our Roth IRA without any tax consequences because it was post tax dollars in the first case?

That sounds awesome!



joe May 8, 2012 at 4:33 pm

Yes, but the warning is that this new deposit will be part of your entire Traditional IRA, and conversions are prorated. This article targets those who have no pre-tax IRA money, so these post-tax deposits would then get converted with no tax due.
Make sense?


Honolulu Aunty May 8, 2012 at 4:54 pm

Yes, makes sense. So what if I open a brand new regular IRA and fund it with after tax dollars – let’s use $5000 as the contribution to the account. Then, 100% of whatever I convert will be good to go into the Roth IRA without any tax due?

I guess I didn’t know that I could fund an IRA even if the income limit phase out was exceeded. That is great to know!



joe May 8, 2012 at 5:04 pm

No. On the traditional side, you have one IRA. You may have 5 accounts, but they are part of your one IRA (individual retirement arrangement). So as I offered in the example, if you have any pretax money in your IRA, you would pay tax on conversion. Inherited IRAs are not part of that “One IRA” statement.
But, if one is over the income limit, you are still allowed to deposit post-tax money into your IRA and track it via form 8606. When withdrawn, it’s also prorated, and tracked each year.


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