You can convert a non-deductible traditional Individual Retirement Arrangement to a Roth IRA, but these conversions work very differently than conversions involving deductible IRAs. Your age and your tax bracket largely determine whether such a conversion makes sense. In the long-term, Roth conversions provide you with tax free income, but the taxes you pay in the short-term could offset those savings.
Prior to investing funds in a Roth, you must pay income tax on the money. You do not pay income tax on withdrawals of principal. Furthermore, you pay no taxes on your earnings assuming that you make no withdrawals until you are 59 1/2 or older and until you have kept the money in the account for at least five years. With a traditional IRA, you can invest on a pre-tax basis, but you pay income tax on withdrawals of principal and earnings. With a non-deductible traditional IRA, you invest your money on an after tax basis but unlike the Roth, you do have to pay income tax on withdrawals of earnings.
You can only deposit money into a Roth IRA if your income falls below certain annually set limits. However, income limits do not apply to non-deductible IRA contributions or to Roth conversions. When you convert a traditional IRA to a Roth IRA you have to pay income tax on any funds in the account that have not previously been taxed. Therefore, with a non-deductible IRA conversion you only pay tax on your earnings and not your principal. Depending on how much your account grew, you may or may not have to pay a lot in taxes. You benefit from the conversion because your future earnings are not subject to taxation, whereas you would eventually have paid taxes if you left money in the Roth IRA.
If you invest in taxable securities rather than in an IRA and you sell your securities after more than 12 months of ownership, you pay capital gains tax rather than income tax on your earnings. The long-term capital gains tax rate amounts to 15 percent, whereas income tax brackets rise as high as 35 percent. Someone close to retirement in a high tax bracket may be better off investing in a taxable account rather than investing in non-deductible IRA and then converting to a Roth. A younger investor could keep funds in the Roth for longer and would therefore have more time to offset the initial cost of paying income tax rather than capital gains tax on the converted funds.
Some investors advocate the so-called "back-door" route to Roth investing for high earners. If you deposit money into a non-deductible IRA this year, you could move that money to a Roth next year before the funds have had much chance to grow and therefore you should not have to deal with a huge tax burden. However, when you convert your funds you have to sell the securities that you bought with your initial non-deductible IRA investment. You often have to pay fees to sell mutual funds, while annuities and certificates of deposit contracts usually include penalties that you pay if you break your contract early. Do not overlook these fees when you decide how to invest your non-deductible IRA funds.
- IRS.gov; Retirement Plans FAQs Regarding IRAs; July 2008
- Bankrate.com; Converting Non-Deductible IRA to Roth; George Saenz; May 2011
- SmartMoney; Roth IRA Conversions Still Smart?; Bill Bischoff; April 2011
- USA Today; More People Can Convert to Roth IRAs; it is a Good Idea?; Sandra Block and Christine Dugas; February 2010
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