In our last post, we introduced the idea of circumventing the Roth IRA phase-out rule by contributing to a traditional IRA account and converting it. This post will explain how you can accomplish this.

Circumvent the Income Restriction on Annual Contributions

The first step is to make an annual non-deductible contribution of up to $5,500, or $6,500 if you’re 50 or older, to a new traditional IRA. There’s no income restriction on non-deductible contributions to traditional IRAs. Next, immediately convert the new non-deductible traditional IRA balance into Roth status. Since the new non-deductible traditional IRA’s tax basis equals the amount that was just contributed to that account, the conversion of the account balance to Roth status is a tax-free maneuver, as long as you don’t have any other traditional IRAs.

In this indirect fashion, you can make annual Roth contributions of up to $5,500 (or up $6,500 if you’re age 50 or older), even though you have a high income. If you’re married, your spouse can likely do the same thing. If so, together you can contribute up to $11,000, or up to $13,000 if you’re both over age 50.

The Catches

With most tax strategies, there are some catches. Here are three to be aware of:

First, you must have earned income each year that at least equals your non-deductible traditional IRA contribution for that year. As explained before, you can count both your earned income and your spouse’s earned income if you’re married and file jointly.

Second, you can only take this route if you’ll be under age 70 1/2 at the end of the year in question. Once you hit 70 1/2, you become ineligible to make traditional IRA contributions, and that shuts down this strategy.

Third, if you have one or more existing traditional IRAs, converting the new non-deductible traditional IRA into Roth status will generally not be a tax-free maneuver. That makes this strategy somewhat less-attractive, but it might still be a good idea because your new Roth IRA can be used to earn tax-free income and gains.

An additional option to consider is if you have one or more existing traditional IRAs. If so, think about converting them into Roth IRAs too. That will trigger an income tax hit, but it may be a reasonable price to pay to avoid higher future taxes on the income and gains that will build up in the resulting Roth IRA(s).

Before making any conversion transaction, be sure to consult with your tax adviser to examine all the relevant variables and determine the best course of action.

 

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