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How to Create a Tax-Free Supplemental Retirement Fund

We are in the throes of making sure all of our clients are taken care of for April 15th. I have been telling many of them about a last-minute tax planning idea and thought I would share with a wider audience. In general, you have until April 15, 2013 to make an Individual Retirement Account contribution for 2012. If you qualify, this is a great way to get a last-minute tax deduction on your 2012 tax return. However, many taxpayers do not qualify for either the traditional deductible IRA contribution, or a Roth IRA contribution. Funds in a traditional IRA are tax deferred. However, funds in a Roth IRA are tax free. If you or your spouse has earned income you can make a nondeductible contribution to a traditional IRA. You can then transfer the funds to a Roth IRA. The result is a tax free retirement fund. For an excellent article on the subject see the Forbes January, 2012 article, The Serial Backdoor Roth, A Tax-Free Retirement Kitty.”

There appears to be nothing in the tax law that prevents a taxpayer from making a contribution to a nondeductible IRA and then immediately converting it to a Roth IRA. To our knowledge, the IRS has not made any pronouncements on this strategy. The potential exposure is that the IRS may say that “in substance” the taxpayer is making a nonqualified Roth IRA contribution. To reduce your exposure, put some time between when you make the nondeductible traditional contribution and when you make the conversion. Wait a few months before you make the conversion, or until the subsequent year. At the minimum, keep the two transactions separate.

There an additional consideration. The IRS requires that all rollovers from Traditional to Roth IRAs be done pro-rata.  This means that if you have $80k in deductible contributions and $20k in non-deductible contributions, you cannot choose to rollover just the $20k non-deductible portion.  If you rolled over $20k (20% of your total account value), the government would treat this as you rolling over 20% of the deductible portion ($18k) and 20% of the non-deductible portion ($2k). In other words, there could be a toll charge in converting to a Roth IRA if you have amounts in traditional deductible IRA accounts. Also, keep in mind that workplace SEP IRAs are also considered traditional IRA assets for purposes of calculating pro-rata rollovers.

As always, you need to consult with a tax professional that understands the rules as well as your personal situation.

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