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The impending 3.8% tax on investment income scheduled to become effective in 2013 may have your upper-middle-class clients scrambling to find ways to reinvest their funds. While withdrawals from Roth IRAs will be exempt, clients who will become subject to the new taxes generally aren’t eligible to contribute directly to a Roth IRA. Since the 3.8% tax applies only to taxpayers with adjusted gross incomes over $200,000, investing directly in a Roth won’t work because of the income limits currently applicable to Roth contributions.
Luckily, there is a way around these limits—you can reduce tax liability for your high-income clients while simultaneously increasing their investments in tax-preferred vehicles by advising these clients to invest in an Overfunded Roth.
What Is a Nondeductible IRA?
Even clients who cannot directly invest in a Roth IRA may be able to add funds indirectly through a nondeductible IRA contribution. Nondeductible IRA funds are contributed into the same type of account as traditional contributions. A traditional IRA can hold both deductible and nondeductible funds, and the account owner is tasked with maintaining records of whether the contributions were deductible.
A taxpayer may make nondeductible contributions to an IRA when his or her adjusted gross income is too high to qualify for a tax deduction. Many of your clients will be subject to these income rules—in 2012, a single person who participates in another employer-sponsored plan won’t be able to deduct IRA contributions if his or her income exceeds $68,000 (the limit is $112,000 for married individuals if both spouses may participate in another plan or $183,000 if only one spouse has the participation option).
Investing in a Roth account is similarly limited—individuals must earn less than $125,000 in 2012 to contribute to a Roth IRA, and married couples must earn under $183,000 combined.
This is where nondeductible IRA contributions become attractive: there are no income limits. Your higher income clients are eligible to contribute up to $5,000 ($10,000 per married couple) annually to an IRA, but the contribution is not tax deductible. The annual amounts are increased to $6,000 ($12,000 per married couple) for taxpayers 50 and older.
These nondeductible contributions are allowed as long as the taxpayer is younger than 70 ½ years old and has earned income at least equal to the contribution.
How Does the Conversion Work?
In 2010, income limitations on converting a traditional IRA account into a Roth IRA were eliminated. This allows your upper middle class clients to indirectly contribute to a Roth account that would otherwise be off-limits. As mentioned, the client can contribute $5,000 (or $6,000 if he or she is 50 or older) to a traditional IRA account, foregoing the tax deduction because of income limits. He or she can then convert the funds into a Roth IRA. This process can be repeated each year—allowing your clients to accumulate substantial funds over time.
The account growth between the time that the funds are originally contributed to the nondeductible IRA and the time that the account is converted into a Roth is taxed as ordinary income. When the funds are eventually withdrawn from the Roth IRA, they won’t be subject to income tax or the 3.8% tax on investment income scheduled to take effect next year.
This system of indirectly funneling funds into a Roth IRA will not be effective for clients who already have substantial amounts invested in a traditional IRA because of the “pro rata rule.” This rule requires a taxpayer to include all IRA assets when determining the taxes due on a Roth conversion.
For example, if the client has $95,000 in a traditional IRA and converts $5,000 to a Roth via a nondeductible contribution, the converted amount would be 95% taxable because the traditional IRA is counted as well. There are ways of getting around this—for example, the traditional IRA funds can be rolled into a 401(k)—but the options aren’t appropriate for all clients.
Additionally, if your client needs to access the converted funds he or she will have to pay a 10% penalty if the funds are withdrawn within five years of the conversion (unless the client is 59 ½ or older).
To conclude, while investing in an Overfunded Roth IRA isn’t appropriate for all clients, it may provide a viable option to those upper middle class clients who are otherwise unable to contribute to a Roth. These clients can then enjoy the usual benefits of investing in a Roth—tax-free withdrawals later in life, for example—and also invest in an account that will be exempt from the 3.8% investment income tax scheduled to take effect next year.
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