Nondeductible IRAs-Roth conversions

[Martha]

I just read an article where Ed Slott (the CPA, IRA guy that Nords mentions a lot who has the website www.irahelp.com) recommends for the first time that upper income people who are not eligible for a deductible IRA or a Roth IRA put money in a non-deductible IRA.  Previously he thought that a non-deductible, after tax IRA was not a good move.  He changed his mind because Congress passed a law that removes income limits for conversions to Roth IRAs, starting in 2010.  He recommends putting the after tax money into the IRA and then in 2010 converting the IRA to a Roth.

The risk is that Congress changes the law before 2010 and the income limits are reinstated.

I am thinking about doing this.  It would be agravating to have the money trapped in a traditional IRA, but really, we can't put a whole lot there anyway between now and 2010.  And even if income limits are reinstated, I imagine at some point we will fall within those income limits.

Anyone have any thoughts on this? 

 

[Indexter]

Perhaps you can make some assumptions, and put together a spreadsheet that shows you:

1. How much you'd gain if the law doesn't change

versus

2. How much you'd lose if the law does change.

That will give you a better feeling for whether it's worth the risk.

 

[bamsphd]

Back in graduate school, I surprised a fellow miser prudent friend
with the observation that we should both be contributing to IRAs.
Even though we were relatively poor at the time, and expecting a
much larger income in the near future. My rationale was that we both
had savings, and while we would have more money in the future, we
would not be able to contribute more than the limit in the future at
any price, regardless of how much money we made.

For the past few years, I have never known until February
if my previous year's Roth contribution would be limited.
I still contributed the max, and then recharacterized the
non-deductable amount. This year I know my Roth limit
will be 0, so I have already made my full non-deductable contribution.

If you follow this board, you probably hope/expect to retire early.

Once you retire early, you will probably be able to arrange
at least one year when your income is below the conversion
limit, unless you have a CEO level DB pension coming.
At that point, you pay the piper so you can enjoy
decades with your IRAs, 401ks, ... all converted to Roth.

If you FIRE with more modest means, you probably convert
a little bit at a time calculated to stay below the X% tax rate.

If the 2010 rule remains law, I might pay the piper early to
convert at least some of my funds. However, as I don't expect
a DB pension in my future, I'm pretty confident I will eventually
have at least one window to convert. It just might have to
wait until after ER.

 

[LOL!]

But if you have a deductible and non-deductible IRA money, when you convert a Roth, you cannot just convert the non-deductible monies. 

From Ed Slott's web site:

I have non-deductible IRAs and deductible IRAs and I have kept them in separate accounts. Can I now take out just the non-deductible money and roll it over to a Roth IRA and pay no tax?

No. With the traditional pre-Roth non-deductible IRAs, every dollar is a blended dollar, that is, part deductible and part non-deductible according to the percentage you have of non-deductible IRA contributions to your total IRAs (deductible and non-deductible), whether or not they were kept in separate accounts.

 

[Martha]

But if you have a deductible and non-deductible IRA money, when you convert a Roth, you cannot just convert the non-deductible monies. 

From Ed Slott's web site:

Good point. I don't have any traditional IRAs now so that wouldn't be a problem for me. I think I am going to go ahead and create a nondeductible IRA this year.

 

[Nords]

Once you retire early, you will probably be able to arrange
at least one year when your income is below the conversion limit, unless you have a CEO level DB pension coming. At that point, you pay the piper so you can enjoy
decades with your IRAs, 401ks, ... all converted to Roth.
If you FIRE with more modest means, you probably convert a little bit at a time calculated to stay below the X% tax rate.

I really appreciate the service that Ed has accomplished by educating America about IRAs, and I hope he's a gazillionaire. He's worked hard enough to deserve it.

But despite all their ingenuity, motivation, and insight, guys like Ed have a blind spot-- they can't even spell ER, let alone design tax-avoidance strategies around it. Maybe it's just too small a niche market for them to sell a book to, because I know that they can't possibly imagine they'll ever stop working.

Even if you ER with a humongous pension that carries you from a 28% tax bracket before retirement to a 28% bracket when the pension kicks in, the fact that you ER'd means that you'll still have at least one year below $100K AGI. Better yet, that year will probably have very low earned income and most unearned income will be taxed at cap gains rates (0-5%) or dividend rates (15%).

It's a perfect opportunity to convert a conventional IRA to a Roth up to the top of the 15% bracket. The fact that the cap gains & dividends are taxed separately opens up a big hole in the 15% tax bracket for dumping conversions into. Heck, if you know your retirement tax bracket will be 25% or higher, it's still worth the conversion up to the top of the 25% bracket if you can avoid taxation of your SS, boost your Roth by paying the conversion taxes out of non-IRA funds, and avoid dealing with RMD calculations.

Our conventional IRAs had many years of non-deductible contributions because we'd still get tax-free compounding. When we started converting them to Roths, our conventional IRA basis was over one-third of their value. Having already paid taxes on that basis makes the conversion that much sweeter...

Form 8606 (or tax software) makes the conversion calculation fairly straightforward. By November I can usually predict our AGI, our taxable income, and how much of our conventional IRA I can convert without busting the top of the 15% tax bracket. Unfortunately the conversion can't be delayed past 31 December (unlike contributions) and mutual-fund custodians are usually overwhelmed with conversion requests in December.

Current plan is probably to stay to mid year next year. I will need a number of months to phase out. I have a lateral hire new associate working with me, which will help the phase out.
My goal is for all to go smooth for clients and firm, and if Mr. Apocalypse is right and all goes to heck, I can keep plugging along here indefinately. But I hope to be out by next May or June.

Ack! Your teasing me. I voted June 2006.

My goal is now June 2006, after some of our more risky real estate inivestments pay off.

So, Martha, speaking of earned income, how's the ER decision going?

 

[Martha]

****, I don't know.

EDIT: I haven't worked many hours at all this year. Not working right now. Won't go back in until Tuesday. So it has been mighty easy to keep hanging around, giving away work I don't like, doing the work I do like, getting a little money, benefits, etc.

 

[Nords]

****, I don't know. 
EDIT:  I haven't worked many hours at all this year.  Not working right now.  Won't go back in until Tuesday.  So it has been mighty easy to keep hanging around, giving away work I don't like, doing the work I do like,  getting a little money, benefits, etc.

"If you choose not to decide, you still have made a choice."

Except for the "Tuesday" part, you've pretty much described my life. Does that mean you've defaulted to ER?

 

[Martha]

Whatever it is, it seems to work for now.

 

[LOL!]

But despite all their ingenuity, motivation, and insight, guys like Ed have a blind spot-- they can't even spell ER, let alone design tax-avoidance strategies around it.  Maybe it's just too small a niche market for them to sell a book to, because I know that they can't possibly imagine they'll ever stop working.

OK, nords you need to write a book on this or better yet have a web site.  Or maybe you can get a chapter or appendix in the 2nd edition of Bob Clayton's book?