Background: The annual contribution limits for traditional IRAs and Roth IRAs are the same. For the 2007 tax year, you can contribute up to $4,000 to either type of IRA (or a combination of both). The contribution limit is $5,000 if you are age 50 or older.
Contributions to a traditional IRA may be deductible if you do not actively participate in an employer’s retirement plan and your adjusted gross income (AGI) does not exceed a specified level. Roth IRA contributions are never deductible.
The primary attraction of the Roth IRA is that qualified distributions are completely exempt from income tax. This includes distributions from an account in existence for five years that are made after age 59½, on account of death or disability or to pay first-time home-buyer expenses (up to a lifetime limit of $10,000).
In contrast, distributions from a traditional IRA may be taxed at ordinary income rates. Thus, there is a tax incentive to convert a traditional IRA to a Roth IRA, even though you must pay tax on the conversion.
Tax complications: Under current law, you can convert to a Roth IRA only in a year in which your AGI is less than $100,000. However, a recent tax law change removed the $100,000 AGI barrier, beginning after 2009. Furthermore, for a conversion taking place in 2010, you can spread out the resulting tax over the following two years (i.e., 2011 and 2012).
In light of this pending tax break, some individuals have chosen to set up a nondeductible IRA. Reason: With a nondeductible IRA, only the earnings are taxable when distributions are made. This will enable you to shift more funds to a Roth IRA after 2009.
Caution: Be aware that you cannot simply take distributions from your nondeductible IRA if you have other IRAs. Any distribution is treated as coming on a pro rata basis from each IRA. This means that you might have to pay more tax than you think when you convert to a Roth IRA.
One possible solution is to roll over funds from traditional IRAs to your company retirement plan, such as a 401(k) plan (assuming the plan permits it). If it is handled properly, there is no current tax on the rollover. When you are ready to convert to a Roth IRA in 2010, you will be left with only a nondeductible IRA.
Similarly, you might have your spouse establish a nondeductible IRA if he or she does not have traditional IRAs funded with tax-deductible contributions. Of course, you still must pay tax on your 401(k) contributions after you retire, but you will have some flexibility over the distributions. Generally, distributions from a 401(k) or traditional IRA are required to begin by the year after the year in which you turn age 70½. Also, it is likely you will be in a lower tax bracket in retirement than you are while working full time.
What is the best course of action? Work out a game plan for the future. Don’t hesitate to seek professional guidance in this area.