Roth IRAs and Income Limits

My spouse and I max out our 401(k) accounts. We're not eligible to use Roth IRAs because of income restrictions. Does it make sense to invest in regular IRAs for additional retirement-oriented savings? Or is there another place to better park that type of money?

You ask a timely question. Until recently, we weren't too keen on non-deductible IRAs. If you earned too much money to qualify for a Roth ($110,000 for singles; $160,000 for married filing jointly) and couldn't deduct your contributions, we generally recommended that people invest in taxable accounts rather than traditional IRAs. That way, they'd have fewer restrictions on accessing the money and the earnings would be taxed at a lower rate when they withdrew them in retirement. Traditional IRA withdrawals are taxed at your income-tax rate, which can be as high as 35%, while stocks or funds held in a taxable account (a regular brokerage or fund account) are taxed at your long-term capital gains rate, which is 15% or lower.

That's still a compelling reason to invest in taxable accounts, especially if you minimize your trades or stick with funds that don't create many taxable distributions each year.

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But non-deductible IRAs did just start to get a bit more interesting a few weeks ago after Congress passed a new tax law that will eventually give you a back door to use a traditional IRA to get into a Roth if you wouldn't otherwise qualify. The new law, which goes into effect in 2010, keeps the Roth income limits the same (you still won't be able to contribute if you're single earning more than $110,000 or $160,000 if married filing jointly). But it eliminates the $100,000 income limit for converting a traditional IRA to a Roth.

That means you can start contributing to a traditional IRA now, then in 2010 you'll be able to convert that traditional IRA into a Roth. At that point, you'll have to pay income taxes on your earnings at your top rate, but any earnings after that will come out tax-free in retirement after age 59#189;, as long as the account has been opened for at least five years. If you convert in 2010, you'll be able to spread the tax bill over 2011 and 2012.

And there are other benefits to switching to a Roth. You'll also avoid having to take required mandatory distributions at age 70#189;, which are required with a traditional IRA, and your heirs can inherit a Roth tax-free.

For more information about the new tax law, see What You Should Know About the New Tax Law.