The Roth IRA is a handy retirement planning tool, but its availability may be limited for some individuals. A person’s eligibility to contribute to a Roth IRA depends on the person’s adjusted gross income (AGI) for the year. The Roth IRA contribution limit may be reduced below $5,000 to possibly $0 for people with high incomes. For single taxpayers, the Roth IRA contribution limit is phased out if AGI is between $105,000 and $120,000 and prohibited if AGI is above $120,000. For married taxpayers, the Roth IRA contribution limit is phased out if AGI is between $167,000 and $177,000 and prohibited if AGI is above $177,000. These AGI phase-out ranges apply to the 2010 tax year but may adjust annually based on inflation.
People with high incomes are prohibited from contributing to Roth IRAs, but they may be able to benefit from a Roth IRA conversion. A Roth IRA conversion allows people to transfer their IRA assets to a tax-exempt Roth IRA by paying ordinary income taxes on the tax-deferred amount that is converted. Before 2010, tax law prohibited Roth IRA conversions for people with AGI above $100,000. The income limit was eliminated for 2010 and years forward, so now even high income people can convert to a Roth IRA.
Traditional IRAs do not have an income limit on contribution eligibility. High income individuals may not be able to deduct IRA contributions on their tax returns if they are covered by an employer retirement plan, but high income taxpayers are still eligible to make non-deductible contributions to a traditional IRA regardless of their income amount. This eligibility to contribute to a traditional IRA combined with the eligibility to convert a traditional IRA to a Roth IRA provides the loophole for high income individuals to add money to a Roth IRA.
Let’s walk through an example to demonstrate how the loophole works. Mr. Wealthy earns $200,000 per year, is covered by a retirement plan at work, and does not currently have an IRA. He is not eligible to contribute to a Roth IRA, so he makes a non-deductible contribution of $5,000 to a traditional IRA. Mr. Wealthy’s IRA contribution grows from $5,000 to $6,000 the following year, and he decides to convert the $6,000 to a Roth IRA. Mr. Wealthy does not pay income taxes on the $5,000 that represents his non-deductible IRA contribution, but he must pay ordinary income taxes on the $1,000 of tax-deferred growth. Mr. Wealthy pays the income taxes from his other taxable assets, and after the conversion is completed, he has $6,000 in a Roth IRA .
The tax laws do not specify how long money contributed to an IRA must be held in the IRA before it can be converted to a Roth IRA. Theoretically, an individual could contribute $5,000 to an IRA on day 1 and then convert that $5,000 to a Roth IRA on day 2. However, some financial experts suggest you avoid such obvious exploitation of the loophole by allowing some time to pass between the IRA contribution and the Roth IRA conversion. It may be only a matter of time before the IRS notices people taking advantage of this loophole and decides to change the tax laws.
