Tax-Free Conversion of Non-Deductible IRA Contributions to Roth IRA

In yesterday’s post, I described how you figure the tax cost of converting a traditional IRA to a Roth IRA when you’ve got some non-deductible contributions in the traditional IRA. I used an example of an $80,000 traditional IRA with $10,000 of non-deductible contributions.

Wouldn’t it be great if you could just convert the $10,000 of non-deductible contributions to a Roth IRA, and pay no tax for the privilege of doing so? Well, maybe you can. Here’s a little trick that might work for you. Read on.

If your employer maintains a tax-favored retirement plan, such as a 401(k) plan or a 403(b) plan, and that plan accepts rollovers from IRAs, then before you do your Roth conversion, you roll over the taxable portion of your traditional IRA to your employer’s plan, $70,000 in our example. In fact, you’re not even allowed to rollover your $10,000 of non-deductible IRA contributions to an employer plan. What does that leave you with? A $10,000 traditional IRA, all of which is considered your own non-deductible contributions. You can convert the whole thing to a Roth IRA without paying any income tax for the privilege of doing so! What a country!

Here’s a couple of caveats about the foregoing trick:
• It only works if you qualify for a Roth IRA conversion, i.e., $100,000 or less Adjusted Gross Income in 2009. Or wait until 2010, when the AGI limit goes away.
• It only works if your employer’s plan accepts rollovers from IRAs. Some do, some don't.
• You end up with most of your IRA money in your employer’s plan, subject to its investment and distribution restrictions, as described in February 11’s post and February 18’s post.
• While your retirement money is in your employer’s plan, you won’t be able to Roth-ificate it until you are able to roll it over back into an IRA.

But if you can get over these hurdles, you end up moving your non-deductible IRA contributions into a better savings bucket. Take that, IRS!