The expiration of the current tax code and the beginning of the new Medicare tax in 2013 may have taxpayers searching for strategies to lessen their tax bite. Withdrawals from Roth IRAs will be exempt from the new tax. One goal to consider should be to get as much money into a Roth as possible. The problem for upper income taxpayers is how to contribute to a Roth IRA with the income limits currently in place. Contributions to a Roth are limited by your adjusted gross income (AGI). This year, individuals must earn less than $125,000 and married couples must earn under $183,000 combined.
There is a way around these limits. The strategy takes advantage of the nondeductible IRA, which does not have an income limitation. A traditional IRA can hold both deductible and nondeductible funds. The hassle will be maintaining records of non-deductible contributions and documenting this on your tax return each year a contribution is made.
The strategy calls for making nondeductible IRA contributions when your income is too high to contribute directly to a Roth. You can contribute up to $5,000 ($10,000 per married couple) annually, 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. Once the contribution is made, you convert the nondeductible IRA to a Roth IRA. Since 2010, there are no income limitations for Roth conversions. This allows upper income taxpayers to indirectly contribute to a Roth account that would otherwise be off-limits.
This strategy of indirectly contributing funds into a Roth IRA will not be effective for taxpayers 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. While investing indirectly in a Roth IRA isn’t appropriate for everyone, it can provide a viable option to those with higher incomes who are otherwise unable to contribute to a Roth.