Funding a tax-deductible Traditional IRA will garner you an immediate tax break, investments grow tax deferred, but withdrawals are taxed as ordinary income. A Roth doesn’t offer an immediate tax deduction but investments grow tax deferred and withdrawals are tax free. Unfortunately, if you are covered by a retirement plan at work and make more than $116,000 if you are single and $169,000 if you are married filing jointly – you can’t contribute to either.
Non deductible IRAs in the past were a very un-popular investment vehicle. Contributions are not deductible on your tax returns, they grow tax deferred but are withdrawn at regular income tax rates. However, in 2006 a new law was passed that said in 2010 individuals who were restricted from contributing to a Roth IRA are allowed to convert their non deductible and deductible Traditional IRAs to Roth IRAs regardless of salary.
Converting your non deductible to a Roth in 2010 without paying additional taxes is an excellent strategy. However, be careful not to trigger more tax liability! Lets say you have $100,000 in a regular Traditional IRA and $25,000 in a non-deductible account. You would owe taxes on the $21,000 because it would be assumed that the $25,000 was coming pro rata from the whole IRA rather than just the non deductible IRA. You don’t want to pay taxes twice so what can you do?
Solution #1: Roll the deductible portion of your Traditional IRA into a 401(k) if allowed. Then when you go to roll over the non deductible portion into a Roth you will not be double taxed!
Solution #2: Even if you have a large IRA that you don’t want to mingle with non deductible IRA money to be converted, your spouse may not. If not, your spouse can fund a non deductible IRA until 2010 and then convert it to a Roth.