Friday, March 23, 2007

New Roth conversion eligibility rule and solo-401(k)

One of the most exciting developments in terms of retirement savings for high incomer earners in last year’s Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA, signed by President Bush on May 17, 2006) was elimination of the Roth conversion eligibility limit after 2009. In addition, in 2010 only, the extra tax incurred for this conversion can be spread over two years. Currently, married joint filers can convert their traditional IRA into Roth only if their modified adjusted gross income (MAGI) is under $100,000. Somewhat perversely, this provision is billed as a means to increase revenue, since taxes will have to be paid for the traditional to Roth conversion (at the expense of future tax revenue -- but that's someone else's problem).

Today, joint/single filers with MAGI over $160,000/$110,000 are not eligible for Roth contribution. Phase-in starts at $150,000/$95,000 respectively. Non-deductible traditional IRA is pretty much the only IRA option for these people, assuming they are not self-employed. Many financial advisors are pointing out that the elimination of conversion eligibility limit creates a loophole where high income earners can simply contribute to a non-deductible IRA and immediately convert it into a Roth. The high income earner gets the Roth benefit without additional income tax liability. This plan works as advertised only if there is no other IRA with pre-tax contributions (traditional, SEP etc.). Since the IRS treats all non-Roth IRAs as a single pool of money, it’s impossible to single out the after-tax contribution for Roth conversion if there are other pre-tax contributions.

For example, if you're a high-income individual and you have $36k pre-tax contributions in existing IRAs. After 2009, you make a $4k post-tax contribution to a non-deductible IRA and immediately covert it to a Roth. Unfortunately, once the $4k hits the pool of IRA money it immediately commingles with the rest. Your $4k conversion will be composed of $400 of post-tax money and $3600 of pre-tax money which is taxable as ordinary income.

Because of this limitation and the fact that the high income individual is in a high tax bracket, this maneuver doesn't necessarily make sense. [To calculate the actual income tax liability requires knowing the value of the IRAs and the basis in them. Some might still decide to do the Roth conversion even though they incur extra tax doing so.] However, all is not lost.

It’s a curious fact that although 401(k) plans share many of the characteristics as traditional IRAs, they are not included in the pool of IRAs when considering the characteristics of the withdrawals/conversions. Thus some interesting possibilities present themselves.

  1. For those intending to take advantage of the new Roth conversion rule and changing jobs between now and 2010, the best thing to do with their 401(k) is to leave them with the old employer or roll-over to the new employer’s 401(k) instead of rolling over to a traditional IRA.
  2. For those self-employed, consider a solo-401(k) [aka self-employed 401(k)] instead of a SEP-IRA if there is no employee other than the spouse.
  3. More research needs to be done but the Fidelity solo-401(k) appears to accept roll-over from a traditional IRA. If that were true, one can simply roll-over all IRAs with pre-tax contributions and voila, the trick mentioned above works beautifully!

In conclusion, those above the Roth eligibility limit and planning on doing the conversion should contribute to non-deductible IRAs now. Those having IRAs with pre-tax contributions should explore the possibility of rolling them into 401(k)s. By the way, the bar for establishing a solo-401(k) is not high. Check out these two articles at MyMoneyBlog (link 1, link 2) for more information. I have a sneaky suspicion that several PF bloggers would benefit from this financial maneuver.

Disclaimer: I’m not a tax professional. Make sure you consult with a CPA/financial planner before making any decisions.