Advanced Underwriting Consultants

Ask the Experts – March 7

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My client earns too much (around $250,000) to make a Roth IRA contribution. Can he instead make a traditional IRA contribution and thereafter convert it to a Roth IRA?

Answer: Yes. While there are income limitations for making contributions to Roth IRAs, there are no such limitations for either a non-deductible contribution to a traditional IRA or a conversion of a traditional IRA to a Roth IRA.

Therefore, assuming your client doesn’t currently own an IRA, he could make a nondeductible $5,500 to a new traditional IRA, and thereafter convert it to a Roth IRA. This essentially results in a Roth IRA contribution.

However, if your client currently owns an IRA with pre-tax money, he should be careful not to trigger more tax consequences than he’d like.

For example, let’s say your client makes a $5,500 non-deductible contribution to his already existing traditional IRA with $49,500 pre-tax money. He pays taxes on the $5,500 contribution and his IRA is now worth $55,000, consisting of 90 percent pre-tax, and 10 percent after-tax contributions.

Here’s the problem: if he tries to convert $5,500 of the traditional IRA to a Roth, he will owe another taxes on an additional $4,950 income. This is because when an individual makes a distribution from an IRA with both pre- and after-tax money, the distribution consists of both pre- and after-tax money on a pro rata basis.

Therefore, if your client converted $5,500 from his traditional IRA to his Roth, only $550 would be with after-tax money, whereas $4,950 would be converted using pre-tax money—meaning he would owe taxes on an additional $4,950 of income. In the end, his $5,500 contribution would incur taxes on $10,450 of income ($5,500 + $4,950).

He could avoid the extra $4,950 of taxable income in the above example by making a deductible contribution to his traditional IRA (as opposed to a non-deductible contribution). If he does this, he will not pay income taxes on the original $5,500 distribution, but instead will owe taxes on the conversion. This tax result is identical to making an after-tax Roth contribution, but because of his income levels, he can only make a deductible contribution to a traditional IRA if he is not an active participant in an employer-sponsored plan.

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