and the Roth IRA
New Planning Opportunity for High-Income
By Mary Bader and Steve Schroeder
MAY 2007 - The
Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA; P.L.
109-222) eliminated the $100,000 modified adjusted gross income
(AGI) limit that currently exists when a taxpayer converts a traditional
IRA to a Roth IRA. The removal of the modified AGI limit takes effect
in 2010. Under TIPRA, income from a 2010 conversion of a traditional
IRA to a Roth IRA is included in the taxpayer’s income over
a two-year period, beginning in 2011. Although removal of the limit
takes effect in 2010, certain high-income taxpayers may benefit
by planning in advance for this conversion.
TIPRA, IRC section 408A(c)(3)(B) prohibited a taxpayer from making
a qualified rollover from a traditional IRA to a Roth IRA if the
taxpayer’s modified AGI for the taxable year exceeded $100,000.
Similarly, IRC section 408A(c)(3)(A) limits a taxpayer’s
ability to contribute to a Roth IRA when the taxpayer’s
AGI is $95,000 or more ($150,000 for a joint return). TIPRA removed
the modified AGI limit for qualified rollovers, but left the AGI
limit for contributions in place. After TIPRA, the effect of the
contribution limit can be avoided with proper planning.
408A(c)(3)(A) limits are enforced under sections 4973(a) and (f)
by imposing a 6% excise tax on a taxpayer who makes an excess
contribution to a Roth IRA. As a result, a high-income taxpayer
has effectively been prohibited from establishing a Roth IRA or
converting a traditional IRA to a Roth IRA.
a high-income taxpayer may be in a position to indirectly fund
a Roth IRA for the first time, beginning in 2006. Section 512
of TIPRA repealed the $100,000 modified AGI limit on converting
a traditional IRA to a Roth IRA, effective for tax years beginning
after December 31, 2009. Unless a taxpayer elects otherwise, income
from the conversion is taxed over a two-year period, beginning
in 2011. As noted above, TIPRA did not change the $95,000/$150,000
AGI limit for contributing to a Roth IRA, nor the imposition of
a 6% excise tax for excess contributions to a Roth IRA under IRC
to a traditional IRA by a high-income taxpayer may not be deductible
under IRC section 219(g) if the taxpayer participates in an employer-sponsored
pension plan. Nondeductible contributions are generally not subject
to the 6% excise tax under section 4973, unless the contribution
amounts exceed the maximum deduction amounts set forth in section
219(b). In 2006 and 2007, the maximum contribution amounts are
$4,000 for taxpayers under age 50 and $5,000 for taxpayers 50
or older by the end of the tax year.
created by TIPRA for a high-income taxpayer to indirectly contribute
to a Roth IRA may have significant financial benefits. For planning
purposes, the benefits of a “back-door” Roth IRA will
depend on the taxpayer’s existing retirement savings plans,
current and future expected marginal tax rates, and expected return
turned 50 in 2006. She has participated in her employer-sponsored
pension plan for the last 20 years. She is married and files a
joint return with her husband. Their combined AGI has exceeded
$200,000 for the last 10 years. Tiffany has never contributed
to a traditional IRA because she was not eligible to deduct her
contributions. She has not contributed to a Roth IRA either, because
her AGI has always exceeded the $150,000 limit. Tiffany’s
current and expected marginal rate is 35% and her expected annual
return on investment is 8%. During 2006 and 2007, Tiffany makes
nondeductible $5,000 contributions to a traditional IRA. In 2008
and 2009, Tiffany makes nondeductible $6,000 contributions to
a traditional IRA. In 2010, Tiffany elects to make a qualified
rollover contribution from her traditional IRA to a Roth IRA.
nondeductible contributions generate an 8% pretax return on investment,
her traditional IRA account will grow to approximately $26,500
in 2010 (depending on when the contributions are made). When Tiffany
elects to convert her traditional IRA to a Roth IRA, she will
pay tax on approximately $4,500 of earnings. Under TIPRA, she
will report half of the earnings in income in 2011 and half of
the earnings in income in 2012, which will result in a federal
tax liability of around $800 for each year. Assuming Tiffany pays
the tax using funds outside of the IRA and her return averages
8%, the $26,500 balance in her Roth IRA will grow tax-free to
approximately $182,000 in 25 years.
current and future marginal tax rates are expected to be the same,
the advantages of a Roth IRA over a traditional IRA are clear.
In addition to the higher after-tax return it will generate because
she has already paid taxes on her contributions, the Roth IRA
balance is not subject to the required minimum distribution rules,
and it will not result in income in respect of a decedent.
a nondeductible traditional IRA between 2006 and 2009, and then
electing to covert it to a Roth IRA in 2010, a high-income taxpayer
with no pre-existing traditional IRAs will be able to fund a Roth
IRA at a minimal tax cost. A high-income taxpayer would have been
unable to do this prior to TIPRA. Note that the tax cost will
be much higher if a taxpayer has an existing traditional IRA account
funded with pretax dollars, due to the aggregation rules of IRC
section 408A(d)(4). Advisors should discuss this planning opportunity
with taxpayers who have previously been unable to fund a Roth
IRA, to determine whether this provision of TIPRA will benefit
them. Taxpayers who will benefit from this change would have maximized
the benefit if they made nondeductible traditional IRA contributions
by April 17, 2007. TIPRA has made it possible for high-income
taxpayers with no pre-existing traditional IRA accounts to fund
Roth IRAs at a modest tax cost, an outcome that may not have been
contemplated by Congress.
Bader, CPA, JD, LLM, is a professor of accounting at
Minnesota State University Moorhead, Moorhead, Minn. Steve
Schroeder, CPA, is senior tax manager at Eide Bailly
LLP, Fargo, N.D.