If your goal is to contribute on a regular basis to a nontaxable investment account without investing in low-yielding tax-free municipal bonds from which you can take nontaxable distributions beginning at age 59-1/2 and assuming you can live with the annual contribution limits, IRS has provided you with this opportunity. Depending on the amount of your income each year, you will be able to achieve your goal in either one or two steps.
In 2010, if your modified adjusted gross income (“MAGI“) is less than $105,000 if you’re single or $167,000 if you’re married filing a joint return, you can contribute up to $5,000, or $6,000 if you’re 50 and over, to a Roth IRA assuming that you receive taxable compensation of at least these amounts. Your Roth IRA distributions will be nontaxable provided that you (a) don’t take any distributions for at least five years after you make your first Roth IRA contribution and (b) wait until you reach age 59-1/2 to take your distributions.
What if your MAGI exceeds the above thresholds and you’re therefore not eligible to make Roth IRA contributions, how do you achieve the goal stated at the outset of this blog? It can be done, however, you will need to do it in two steps as follows:
- Make nondeductible IRA contributions.
- Convert nondeductible IRA contributions to a Roth IRA.
Step 1: Make Nondeductible IRA Contributions
Assuming that your MAGI exceeds the stated thresholds for making Roth IRA contributions, you can make deductible contributions to a traditional IRA assuming that you aren’t an active participant in an employer-sponsored retirement plan. If you do this, however, 100% of the withdrawals from your IRA will be taxable. If, on the other hand, you’re an active participant in an employer-sponsored retirement plan, you can make non-deductible IRA contributions up to $5,000 or $6,000 if you’re 50 and over to a traditional IRA assuming that you receive taxable compensation of at least these amounts.
When it comes time to taking distributions, the good news is that the portion of your distributions representing contributions to your IRA will be nontaxable. If you leave your nondeductible contributions in a traditional IRA, you will not achieve your goal of nontaxable distributions, however, since the portion of your distributions representing earnings will be taxable as ordinary income. This could be substantial assuming you consistently make nondeductible maximum-allowable contributions over many years.
Step 2: Convert Nondeductible IRA Contributions to a Roth IRA
There is a second step that you need to follow religiously each year after making your nondeductible IRA contributions if you want 100% of your IRA distributions to be nontaxable. Immediately after making your nondeductible contributions to your traditional IRA account, you need to convert 100% of your contributions to a Roth IRA. Once your traditional IRA funds are transferred to your Roth IRA, none of the distributions from your Roth IRA will be taxable, including earnings, provided that you don’t take any distributions for at least five years after you make your first Roth IRA contribution and you wait until you reach age 59-1/2 to take your distributions.
As an example of the potential power of using this strategy over an extended period of time, including illustrating the differences in taxation between deductible traditional IRA’s, nondeductible traditional IRA’s, and Roth IRA’s converted from traditional nondeductible IRA’s, please see Projected IRA and Taxable IRA Amounts spreadsheet. The spreadsheet was prepared using the following assumptions:
- Maximum annual contributions to nondeductible traditional IRA’s from age 40 through age 69 on January 1st of each year
- Immediate conversion of nondeductible contributions to Roth IRA
- Maximum allowable annual contributions beginning at $5,000 increased by $500 per year every five years with additional $1,000 per year “catch-up” contributions beginning at age 50
- Earnings at 5%
- No withdrawals before age 70
Given the foregoing assumptions, per the spreadsheet, the projected value of the Roth IRA at age 60 would be $446,773, none of which would be taxable. Assuming that the nondeductible IRA contributions remain in a traditional IRA and aren’t converted to a Roth IRA, 100% of the projected earnings of $239,273 would be taxable. Finally, with a traditional deductible IRA, 100% of the projected contributions and earnings of $207,500 and $239,273, respectively, for a total of $446,773 would be taxable.
As you can see, it’s possible to accumulate a sizeable nontaxable nest egg if you start early and commit to making regular annual contributions. As an added bonus, because your funds are sitting in a Roth IRA, in addition to your withdrawals being nontaxable, they’re also not subject to the required minimum distribution rules.