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Loophole in IRS Law for IRA Roth Contributions

Loophole in IRS Law for IRA Roth Contributions

Old Mar 31st 2014, 1:01 am
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Smile Loophole in IRS Law for IRA Roth Contributions

Normally if your income exceeds a certain amount, you can't make IRA Roth contributions but there appears to be a loophole in the tax code to get around this.

People are allowed to convert traditional IRAs to Roth IRAs if they pay the taxes. Anyone up to the age of 70 1/2 can make contributions of up to $5,500 per year to a traditional IRA but if you or your spouse's company has a 401K plan, the contributions have to be after tax contributions. You can also elect to make after tax contributions instead of pre-tax contributions.

If a traditional IRA is funded with after tax contributions, the tax has already been paid on those contributions and if the person immediately converts the traditional IRA to a Roth IRA, no additional taxes will be owed. Since all Roth IRAs are funded with after tax contributions, effectively this is the same as contributing directly to a Roth IRA.

However there is one caveat. You can not currently own any pre-tax traditional IRAs, SEPS, and SIMPLE IRAs to get the full tax benefit since the government treats all non Roth IRAs as one IRA and when conversions to a Roth IRA is performed, proportional conversions from all IRAs are calculated to determine income that has to be reported as additional income.

IRA Contribution Limits

Roth IRA Deduction Limits

Tax Implications of IRA Contributions

Roth IRA Conversions

The following from the last link explains why there is no tax due.

You will be subject to income taxes on the taxable amount that you convert to a Roth IRA. The taxes will be calculated based on your marginal income tax bracket and the amount of money you convert from your Traditional IRA or employer plan assets. You'll need to complete IRS Form 8606 to report your "basis" (if any; generally, this relates to nondeductible or after-tax contributions previously made) in your Traditional IRA and to report your taxable conversion income to the IRS.

Therefore if $5,500 is contributed to a traditional IRA as after tax contributions, you don't own any non Roth IRAs, and a conversion is immediately performed, the basis is $5,5000 and therefore there is no taxable conversion income.

The advantages of a Roth IRA is that gains, dividends, and interest are not taxed after age 59 1/2 and is held for at least 5 years, trading can be done without tax implications, and contributions can be distributed at any time without tax consequences. So basically if it similar to a tax free saving or brokerage account where you can always withdraw the contributions.

Roth IRA Distributions

Also for people retiring back to the UK, I believe that distributions from a Roth IRA is not taxable in either the US or the UK.

Be careful for those that are likely retired and want to directly contribute to a Roth IRA since that may not be able to be done if you don't have earned income.

Last edited by Michael; Mar 31st 2014 at 2:05 am.
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