Fund regular IRA now, convert it to Roth later

Your Money

May 20, 2007|By Humberto Cruz | Humberto Cruz,Tribune Media Services

I opened a traditional IRA in 1992. I now live with my husband and two children in North Carolina. We started a small business and lost quite a bit of money but finally have more than we need to live on. However, I'm confused as to how to save for retirement. If I understand correctly, we are not eligible to contribute to a Roth IRA because our income is too high. I did not make regular contributions to my traditional IRA, so it's still small. What do we do? Fund traditional IRAs? I am still self-employed, and my husband's company has a 401(k) but does not match his contribution. Do we invest in stocks and mutual funds that aren't retirement accounts? That makes me nervous. Everyone says Roth, but we can't do Roth, so I'm stuck. I don't want to stay stuck.

There's no need to be stuck or nervous.

First, check whether you are truly unable to contribute to a Roth individual retirement account, which does not offer an immediate tax deduction but, if managed properly, allows all the money to be withdrawn tax free at retirement.

Since Roth IRAs became available in 1998, contributions for married taxpayers filing jointly had been phased out between $150,000 and $160,000 of modified adjusted gross income ($95,000 and $100,000 for singles). That meant if earned income reached those levels, the allowable contribution to a Roth IRA was reduced.

Thanks to the Pension Protection Act, those income limits are now indexed for inflation. For 2007, the phase-out ranges are $156,000 to $166,000 and $99,000 to $114,000, respectively.

Even if your income exceeds the new limit, you may be able to create a future Roth IRA.

First, resume funding your traditional IRA and do so every year through 2010. You would receive no tax deduction, but earnings would accumulate tax deferred. (While you can still contribute, eligibility for deductions phases out at various income ranges depending on filing status and circumstances.)

Then in 2010, convert the traditional IRA to a Roth. That is when a provision expires that prohibits conversions on years that adjusted gross income exceeds $100,000 for singles or joint filers.

When you convert, you owe taxes on any deductible contributions and tax-deferred earnings. But there is no tax on the nondeductible contributions, likely to be the bulk of the account in 2010. (You could continue to fund a traditional IRA and convert it to a Roth every year afterward.) This strategy can make sense for many people, but I suggest consulting a qualified tax or financial adviser first.

In addition to the IRA, if you work for yourself. with no employees, or if your spouse is your only employee, you can set up a "solo" or "self-employed" 401(k) plan. These plans allow you to contribute part of your pay ($15,500 limit this year or $20,500 for people age 50 and older) plus up to 25 percent of your business profit in your dual role as employee and employer. Fidelity Investments and T. Rowe Price are among no-load, direct-marketed investment firms offering these plans.

Your husband, meanwhile, can contribute to his 401(k), even if there is no match, and also can set up a future Roth IRA by the process outlined earlier.

And you both can invest in stocks and mutual funds outside retirement accounts. Stocks and mutual funds are no more or less risky because they are inside or outside retirement plans. Retirement plans provide tax-favored status, not protection against investment loss.

Humberto Cruz writes for Tribune Media Services.

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