Beating the Roth IRA Contribution Limits

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By Roy Lewis
February 9, 2001

When can you make a Roth IRA contribution when you're not technically allowed to? Sound like double-talk? Well... we ARE dealing with taxes here. But just as three left turns equal a right turn, there is a method by which you can make a Roth IRA contribution when it would seem that you're not eligible. You'll have to make a few left turns... the direct route won't work. But it might be something that you should consider. Which is why we'll take a look at...

Roth IRA Contribution Limitations

As you already know, if you are a single person and your modified adjusted gross income (AGI) is greater than $95,000, your Roth IRA contribution is limited. And when your AGI reaches $110,000, you are no longer allowed to make a Roth IRA contribution.

And as you also know, the modified AGI limitation for a Roth IRA conversion is $100,000, and this is so regardless if you're single or married filing jointly.

A few of you fast thinkers out there might notice that there is a bit of an overlap between the AGI limitations for singles to make a contribution and the AGI limitations for a conversion. And it's that overlap that we'll show you how to exploit.

Still don't quite see it? Well, let's take a look at the situation of my new friend, Sage Brush.

Sage Beats the System

Sage really works hard to manage his income and AGI as any smart Fool would do. Sage is a single guy, and he knows that his income will fall somewhere between $95,000 and $100,000. He also knows that if he wants to make a Roth IRA contribution, his contribution will be limited to less than the full $2,000 maximum contribution. That's not something that he really wants -- he wants to make his entire contribution.

So what can he do? Well, he can make a non-deductible traditional IRA contribution in say, mid or late December, when he is assured that his modified AGI will be below $100,000. Then he immediately makes a Roth IRA conversion from the traditional IRA account to his Roth IRA account.

Bingo! He's got a $2,000 Roth IRA contribution. Since he makes his conversion virtually immediately after his non-deductible traditional IRA contribution, there will likely be no earnings to convert, and therefore no (or very little) tax on the conversion. And, since he's making a non-deductible traditional IRA contribution initially, he doesn't bump up against the modified AGI rules attributable to deductible traditional IRA contributions. So Sage has it made. He gets a full $2,000 Roth IRA contribution when he would normally be allowed something less than a full contribution.

The Two-Year Gambit

This will work even if Sage has mucho income in one year as long as his income comes back to earth in the next (or some future) year. Let's look at another scenario.

Let's say that Sage's income in year #1 amounts to $150,000 because of a large one-time bonus that he received. In year #2, Sage is virtually certain that his modified AGI will drop below the $100,000 amount. Sage's year #1 AGI is way above both the Roth IRA limitations, so making a contribution and a conversion in the same year won't work for Sage.

But remember that Sage believes that his income will come back to "normal" in year #2. So what can he do? Well, he makes a non-deductible traditional IRA contribution in year #1 (perhaps in December). And then, in year #2 (perhaps in January), Sage makes a conversion from his traditional IRA to a Roth IRA. Again, because of the planned timing, the earnings on the account will be virtually nil, which will avoid any tax issues on the conversion from the traditional IRA to the Roth IRA. And, since the traditional IRA is deemed non-deductible, Sage won't have to worry about any AGI contribution limitations in year #1.

So, in effect, Sage has made a Roth IRA contribution when one was not allowed. He just used the back door to do it, and also utilized some interesting quirks in the tax law to make the whole thing happen.

When It Won't Work

Obviously, if you can never get your modified AGI below the $100,000 limitation, you'll never be able to make a conversion from your traditional IRA account to your Roth IRA account. And even if you think that your AGI will drop at some time in the future, the longer it takes, the more you'll get hit for taxes on your traditional IRA at the time of conversion to a Roth IRA. And, if your AGI never drops below $100,000, all you'll have is a traditional IRA with a bunch of non-deductible contributions and (you hope) a whole bunch of earnings. Worse things could certainly happen to you, but if you're looking for the benefits of a Roth IRA, you might not be quite able to get there.

However, if you can manage your AGI and expect your AGI to drop below the $100,000 limitation, you might be able to use this little gambit to effectively make a Roth IRA contribution when one is technically not allowed.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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