A while back, there was an article from the Wall Street Journal that discussed a way for high-income couples to make Roth IRA contributions.
A physician and his wife were maxing out their 401(k) accounts and 457 savings plans, but were ineligible for deductible contributions to a traditional IRA or contributions to a Roth IRA due to their high income. Their financial advisor recommended a simple strategy. The husband and wife each opened a nondeductible, traditional IRA account and made after-tax contributions of $6,000 each, for a total of $12,000. The advisor invested the nondeductible IRA in a low-yielding money market account.
Although Roth contributions are normally limited to couples filing jointly who earn $196,000 or less, there is no limitation for Roth IRA conversions. The day after maxing out their annual contribution to the traditional IRA, the clients rolled over the $12,000 from their traditional IRAs to new Roth IRAs. Because the rollover triggers income tax only on the appreciation of the after-tax contributions, after only one day in the traditional IRA, there would be little to no appreciation of the funds invested in the money market account.
Now the client’s money in their Roth IRA can compound tax-free. They repeat the technique each year using the same traditional and Roth IRA accounts. Once the couple reaches their 50’s, the annual contribution limit will be $14,000 per year. Drawing from the Roth IRA will help reduce the income taxes the couple will owe in retirement when they start taking distributions.
This technique is not for everyone. It works best for young professionals with high incomes that don’t already have a large amount of savings in a traditional IRA. The “pro-rata” rule requires clients with pre-tax contributions in a traditional IRA as well as nondeductible IRA contributions to divide the value of their nondeductible contributions by their total IRA assets to determine what percentage can be converted tax-free. Still, under the right conditions, this solution allows clients to maximize their retirement savings with very little investment of their time.
If you need help with your IRA contributions, don’t hesitate to contact a Henry+Horne professional adviser.