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?