TIPRA and the Roth IRA
New Planning Opportunity for High-Income Taxpayers

By Mary Bader and Steve Schroeder

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Prior to TIPRA

Prior to 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.

The section 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.

After TIPRA

After TIPRA, 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 Section 512 of TIPRA repealed the $100,000 modified AGI limit on converting a traditional IRA to a Roth IRA, effective for tax years beginning after December 31, 2009.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 section 4973.

Contributions 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.

The opportunity 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 on investment.

Example

Tiffany 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.

If Tiffany’s 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.

If Tiffany’s 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.

Planning Points

By establishing 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.

Mary 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.

©2009 The New York State Society of CPAs. Legal Notices