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Suze Orman Money Matters

Suze Orman, Money Matters

An IRA Nest Egg You Can’t Pass Up

by Suze Orman

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Posted on Thursday, November 30, 2006, 12:00AM

I'll bet that right about now you're focused on all the gifts you want to get for your family and friends. But please don't overlook what I consider the must-have gift for yourself in any season: a non-deductible IRA.

That might not sound as exciting as the latest gaming console, but what if I told you that my gift idea could potentially create a six-figure retirement nest egg that's absolutely tax-free? Not tax-deferred -- tax-free.

A Can't-Miss Opportunity

Now that I have your attention, here's the deal: This past spring, Congress passed a new law that will make it possible for everyone -- regardless of income -- to convert their IRAs into a Roth IRA beginning in 2010.

That's a huge investment opportunity, because money you eventually withdraw from Traditional IRAs is taxed at your income tax rate, while all Roth IRA withdrawals are 100-percent tax-free if you've had the account at least five years and wait until you are 59-1/2 to make withdrawals.

While high income earners (singles or couples making more than $100,000) still won't be able to invest directly in a Roth IRA, this new ability represents a great opportunity.

If you've previously shunned IRAs, the best move you can make between now and 2010 is to invest as much as possible in a Traditional IRA. Then, in just over three years, you'll have a nice sum you can convert to a Roth IRA.

The Rules of the Game

Here's what you need to know about IRAs:

  • Everyone can contribute to a Traditional IRA, but not everyone can deduct their contribution.

    In 2007, the maximum annual IRA contribution will be $4,000 ($5,000 if you're at least 50 years old). If you aren't eligible for a retirement plan offered through your job, you're allowed to deduct your IRA contribution regardless of your income. Otherwise, the deduction is allowed only if you're single with income below $62,000 or married and file a joint tax return with an income below $100,000.

    The married limit rises to $103,000 in 2007. (If only one of you has a plan at work, the income limit for IRA deductibility is $166,000.) But here's what many higher-income folks overlook: If your income is above those cutoffs, you can still invest in a Traditional IRA and benefit from the tax-deferred growth of your account.

    The only catch is that you can't deduct the contributions that you make to your IRA. That's why this type of IRA is known as a non-deductible IRA. When you reach retirement age and make withdrawals from a non-deductible IRA, you'll owe income tax -- but only on the amount above the contributions that you originally put in.

    A non-deductible IRA is simply a Traditional IRA in which you don't get any upfront tax break on your contribution. Thus you don't have to pay taxes on those contributions when you withdraw them.

  • Not everyone can contribute to a Roth IRA.

    The rules are different here: Only individuals with incomes below $114,000 and couples filing a joint tax return with an income below $166,000 can invest in a Roth IRA. If your income is above these thresholds, a Roth is out of bounds.

    Up to now, that's meant that high-income earners have been shut out from directly investing in Roths.

  • Currently, not everyone can convert a Traditional IRA to a Roth IRA.

    As of right now, you can convert a Traditional IRA to a Roth only if your adjusted gross income is below $100,000. That's the limit whether you're single or married.

A Real-World Scenario

Here's where things get interesting. Come 2010, the $100,000 conversion limit vanishes. Anyone, regardless of income, can convert money in a non-deductible or Traditional IRA into a Roth IRA. No strings attached.

That brings us back to my original point: The best gift for high-income earners is to open a non-deductible IRA, because in 2010 you'll be able to convert the money into a Roth IRA.

Yes, you'll owe taxes on any account gains that have accrued between now and your conversion, but once you get the money into a Roth you have a 100-percent tax-free account.

Let's say you're 35 years old and decide to open up your first Traditional IRA by investing the maximum $4,000 this year, and then another $4,000 in 2007. When the max rises to $5,000 in 2008, you stash that sum away in 2008, 2009, and 2010. That's a total of $23,000.

Let's assume that in 2010 the IRA's total value has risen to $28,000. That's $5,000 in gains over what you originally deposited. If you convert the Traditional non-deductible IRA into a Roth, at that point you'll only owe income tax on the $5,000 in gains your account accrued.

Happy Holidays to You (or Your Heirs)

The new law even makes it easy to handle the conversion tax bill. If you convert in 2010, you can spread your tax bill over two years -- 2011 and 2012. (You can also choose to convert smaller amounts over as many years as you want as a way of minimizing your tax bill in any single year.)

Once you convert the money, that $28,000 grows tax-free. And if for whatever reason in 2016 (five years after your conversion) you happen to need money, you can withdraw any amount from your converted Roth IRA up to the $28,000 without any additional tax or penalty, even though you'd only be 45 old.

But let's assume you won't touch the money. If you convert the $28,000 in 2010 and it keeps growing at an average of 8 percent a year for the next 20 years, you'll have more than $130,000. That's $130,000 that Uncle Sam doesn't get a penny of.

Even better; if you don't need the money in retirement, you can just let it sit untouched for your heirs to eventually inherit. With a Traditional IRA, you must start making withdrawals by age 70-1/2.

Now do you see why I think you can't afford to pass this up? It's a potential six-figure-plus gift to yourself or your heirs.

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18 Comments

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  • AlexD - Monday, March 26, 2007, 4:02PM ET  Report Abuse

    • Overall: 5/5

    That is TRUE. I opened Roth IRA. Starting from 2006 Contribution. Nice catch !!!

  • Yahoo! Finance User - Monday, March 26, 2007, 11:00AM ET  Report Abuse

    • Overall: 3/5

    As others have noted, Suze does ignore an important fact here - that one must consider all of the IRA holdings when determining the taxes owed upon conversion to a Roth. Check out: http://www.fairmark.com/rothira/expand.htm for more info. Here's a good excerpt: "In either case, you should bear in mind that the income component when you convert to a Roth is determined relative to the total value of all your traditional IRAs. For example, if you happen to have a traditional IRA with $96,000 of money from a 401k rollover (zero basis) and you make a $4,000 nondeductible contribution to a new IRA, thinking you can convert it to a Roth at little or no cost, you'll be wrong. You have to add the two IRAs together to determine the taxable amount, and in this case your conversion will be 96% taxable." This link also states the possibility that the laws could be changed before we get to take advantage of them. In my eyes, that would be the greater disappointment. These facts notwithstanding, Suze does offer some good advice that warrants your attention. Regardless of how the basis is calculated on your "non-deductible" traditional IRA deposits (really only an issue if you do a partial conversion), the fact remains that you are setting aside money to grow for retirement - and much of it can be tax-free. Don't let the perfect be the enemy of the good.

  • Yahoo! Finance User - Monday, February 26, 2007, 4:46PM ET  Report Abuse

    • Overall: 1/5

    Almost did this before I realized that my rollover IRA assets made this a very dumb idea -- the article should make it clear this only works if you have no other IRA assets.

  • ChuckB - Monday, February 19, 2007, 12:50PM ET  Report Abuse

    • Overall: 1/5

    This only works tax-wise if you have few assets in other deductible IRA's (which isn't likely for a high bracket person who probably has been saving already). Otherwise you get penalized for your deductibles and the non-deductible. Suze, print a retraction or clarification - this is misleading.

  • Yahoo! Finance User - Sunday, February 18, 2007, 10:18PM ET  Report Abuse

    • Overall: 1/5

    Giving this one a poor rating for the reason mentioned several times in these comments -- BEWARE of the part Suze left out, the tax is computed based on ALL of your IRA assets... I now have to consider rolling all my deductible IRAs back into my 401(k) so I can convert the non-deductible assets!

  • Yahoo! Finance User - Saturday, February 17, 2007, 10:06PM ET  Report Abuse

    • Overall: 3/5

    On her show I've seen Suze emphasize not placing too much emphasis on taxes when making investment decisions -- at least for the casual investor. This seems to contradict that.

  • Yahoo! Finance User - Thursday, February 15, 2007, 10:24AM ET  Report Abuse

    • Overall: 1/5

    You should convert IRA only if your current tax bracket is lower than that when you are 70 year old. This isn't true for most people.

  • Yahoo! Finance User - Wednesday, February 14, 2007, 11:52AM ET  Report Abuse

    • Overall: 1/5

    Suze made a big mistake by not informing her readers that ALL IRA assets are included in the calculation for taxes when converting to a roth in 2010. If you have a sizable total IRA balance (which could be the case if you have rolled over 401K money into IRA's) you could end up paying taxes on almost your entire nondeductable contribution (in addition to the appreciation from 2006 to 2010). Therefore, you would actually be taxed twice on your nondeductable contribution. Look at form 8606 as another reader suggested. Suze really missed the boat on this one and she should alert her readers so they don't make a huge mistake!

  • Happy Client - Friday, February 2, 2007, 6:46PM ET  Report Abuse

    • Overall: 2/5

    Be careful - There are some huge pitfalls !!! She chose to leave those out.

  • Yahoo! Finance User - Tuesday, January 30, 2007, 1:27PM ET  Report Abuse

    • Overall: 2/5

    Is the IRA account you convert to Roth IRA account in 2010 insulated of tax implications from any other IRA account you have or both will be considered together for tax purposes?

  • Yahoo! Finance User - Monday, January 29, 2007, 8:03PM ET  Report Abuse

    • Overall: 4/5

    and I suppose that if you are able to deduct your IRA contributions now you owe taxes on the total amount converted in 2010, right? Another question: if I already max out my 401k and my Roth IRA, can I still contribute $4,000 to a traditional IRA?

  • Fred - Tuesday, January 23, 2007, 10:20AM ET  Report Abuse

    • Overall: 2/5

    Be careful! This advice is okay, but there's a major risk of problems that Suze does not disclose. First, the law can change before 2010 - who knows what Congress and the president will look like in 2009. You *are* taking a risk that the provision will survive another 3 years, that's no sure thing. Second, and most importantly, if you have a rollover IRA for a 401K of some such, this can be a disaster. The reason is the that law considered all Traditional IRAs to be one for tax purposes. Lets take Suze's example - you have $5K of gains on $23K of non-deductible contributoins. She says that this means that taxes will only be due on the $5K. However, lets say you also have a $72K rollover IRA from an old 401K. In this case you have $100K worth of traditional IRA assets, and only $23K are excluded from taxes. So for ever $10K you move, $2300 is tax exempt, but $7700 is taxable! No matter which IRA you actually take the money from, they're all one to the IRS! Check out IRS form 8606 and do the math yourself should you doubt me. Suze is right to bring up this potential strategy, but she is wrong to ignore the pitfalls. It could get some people in serious trouble!

  • Patricia - Sunday, January 21, 2007, 12:07AM ET  Report Abuse

    • Overall: 5/5

    I have been trying to figure out what kind of IRA that I should get. This article was the most clear and concise information that I found. Thanks.....

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