A Roth Conversion Loophole You Can Use

If you haven’t been eligible for a tax deduction on contributions, you probably haven’t been keen on putting money into a traditional IRA. But it might make sense to rethink that view.

By funding a traditional IRA and then quickly converting to a Roth IRA, you could sidestep rules that otherwise might prevent you from having a Roth, which shelters investment gains from tax.

Starting in 2010, anyone can convert a traditional IRA into a Roth. Previously, only investors with incomes of $100,000 or less could do so.

A quirk in the rules makes the conversion process especially appealing to investors who satisfy three criteria:

• They do not qualify for tax deductions on traditional IRAs.
• They do not already have a lot of money in traditional IRAs.
• They exceed the income limits for opening Roth IRAs.

To make the situation clear, let’s go step by step.

Traditional IRAs

These allow investors to put money aside for retirement, paying no tax on investment gains until money is withdrawn. Investors who don’t have pension plans at work and have incomes below certain levels can deduct contributions from their taxable incomes. A $5,000 contribution would reduce the investor’s federal income tax by $1,250, assuming a 25% tax bracket. The Roth IRA Conversion Calculator can show whether conversion would pay.

Investors who don’t qualify for deductions can make non-deductible contributions, regardless of how much they earn. Many people, however, feel that a traditional IRA is not worth having without the up-front deduction on contributions. These tables from T. Rowe Price (Stock Quote: TROW) show who qualifies for deductions.

Roth IRAs

These do not offer any deduction on contributions but are attractive because all qualified withdrawals, including contributions and investment gains, are tax free. However, people with incomes above certain limits cannot open Roths.