Overfunded Roth IRAs: Shelter for the Upper Middle Class?

In 2010, income limitations on converting a traditional IRA account into a Roth IRA were eliminated. This allows your upper middle class clients to indirectly contribute to a Roth account that would otherwise be off-limits. As mentioned, the client can contribute $5,000 (or $6,000 if he or she is 50 or older) to a traditional IRA account, foregoing the tax deduction because of income limits. He or she can then convert the funds into a Roth IRA. This process can be repeated each year—allowing your clients to accumulate substantial funds over time.

The account growth between the time that the funds are originally contributed to the nondeductible IRA and the time that the account is converted into a Roth is taxed as ordinary income. When the funds are eventually withdrawn from the Roth IRA, they won't be subject to income tax or the 3.8% tax on investment income scheduled to take effect next year.

Potential Pitfalls

This system of indirectly funneling funds into a Roth IRA will not be effective for clients who already have substantial amounts invested in a traditional IRA because of the "pro rata rule."  This rule requires a taxpayer to include all IRA assets when determining the taxes due on a Roth conversion.

For example, if the client has $95,000 in a traditional IRA and converts $5,000 to a Roth via a nondeductible contribution, the converted amount would be 95% taxable because the traditional IRA is counted as well. There are ways of getting around this—for example, the traditional IRA funds can be rolled into a 401(k)—but the options aren't appropriate for all clients.

Additionally, if your client needs to access the converted funds he or she will have to pay a 10% penalty if the funds are withdrawn within five years of the conversion (unless the client is 59 ½ or older).

To conclude, while investing in an Overfunded Roth IRA isn't appropriate for all clients, it may provide a viable option to those upper middle class clients who are otherwise unable to contribute to a Roth. These clients can then enjoy the usual benefits of investing in a Roth—tax-free withdrawals later in life, for example—and also invest in an account that will be exempt from the 3.8% investment income tax scheduled to take effect next year.

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