Many people think IRAs come in two flavors. Traditional IRAs, as they’re known, often hold pretax dollars. They offer tax deferral, but you’ll owe income tax on withdrawals. Alternatively, Roth IRAs are funded with aftertax dollars. Earnings inside the account are tax-free, as they are with traditional IRAs, and withdrawals also are tax-free if you are at least 59½ years old and have had a Roth IRA for at least 5 years. In some cases, however, you might find that you cannot make a deductible contribution to a traditional IRA or a nondeductible contribution to a Roth IRA. If so, you should consider contributing aftertax dollars to a traditional IRA, even though such contributions are not deductible.
Example 1: Paul and Lois Matthews, both age 55, work at jobs where they participate in a retirement plan. Their combined income this year is over $250,000. Neither spouse qualifies for a deductible contribution to a traditional IRA because couples filing a 2012 joint tax return can’t make deductible contributions if they have modified adjusted gross income (MAGI) of $112,000 or more, and if both spouses are covered by an employer’s retirement plan. This couple can’t make Roth IRA contributions, either. For 2012, a couple filing jointly can’t contribute to a Roth IRA if their MAGI is $183,000 or more. However, both Paul and Lois can make full aftertax contributions to a traditional IRA for 2012. Such contributions have no income limits. Because they are both over 50, Paul and Lois can each contribute up to $6,000 to a traditional IRA this year. They’ll get no deductions for their contributions, but they will enjoy other tax benefits.
After contributing nondeductible money to a traditional IRA, all investment earnings are tax-deferred until money is withdrawn. In addition, individuals will owe less tax on Roth IRA conversions and traditional IRA withdrawals.
Example 2: Paul Matthews has no traditional IRA. For 2012, he makes a $6,000 nondeductible contribution to his first traditional IRA. Once the account is open, he converts this IRA to a Roth IRA; there are no income limits on Roth IRA conversions. If Paul’s traditional IRA is worth $6,000, then all of the money is aftertax. Thus, Paul owes no tax on the conversion. He can do this year after year, building up a Roth IRA for eventual taxfree distributions. A quirk in the tax code places no income limits on Roth IRA conversions, even though there are income limits for Roth IRA contributions. As explained in the next example, though, contributing aftertax dollars to a traditional IRA and then converting to a Roth IRA may generate a tax obligation.
Example 3: Lois Matthews has a traditional IRA. For 2012, she makes a $6,000 nondeductible contribution to a new traditional IRA. Lois keeps making such contributions for the next several years. By 2017, Lois has a total of $100,000 in her traditional IRAs. Of that amount, $30,000 is aftertax money and $70,000 is pretax. Lois decides to convert $20,000 to a Roth IRA. Because her traditional IRA money is 30% aftertax, the conversion is only 70% taxable: on a $20,000 conversion, Lois will report $14,000 (70% of $20,000) in taxable income. That will be the result no matter which traditional IRA Lois taps for the conversion. If Lois decides to withdraw funds from her traditional IRA for spending money then, instead of for a Roth IRA conversion, the tax treatment would be the same. Lois would report taxable income equal to 70% of the withdrawal and a 30% tax-free return of aftertax money.