Roth IRA loophole?

[Guest Hopewell]

As a real estate salesperson, my wife is an independent contractor. As such she can contribute to both a Roth IRA and a SEP-IRA. Since assets in a SEP-IRA can be converted to a Roth IRA, is there anything to prevent her from contributing the maximum to both and then converting the SEP-IRA assets to her Roth. Assuming that we qualify and that it makes sense for us to favor a Roth IRA over a SEP-IRA, isn’t this, in essence, a legal way to exceed the normal $3,000/$3,500 cap on annual Roth IRA contributions?

[Appleby]

Hopewell,

I like your way of thinking… however, this is not a loophole.

Yes. Your wife may contribute the maximum amount to both the SEP and the Roth IRA (assuming she meets the eligibility requirements and have sufficient income). A maximum dollar amount of $3,000 for the Roth ($3,500 if she is at least age 50 by the end of the year for which the contribution is being made) and a maximum dollar amount of $40,000 for the SEP IRA. There are rules that may reduce this amount, depending on her income (or - adjusted net business income (ANBI) if she is she operates as a sole proprietorship).

However, you must look at this as two separate animals (sic). Making an employer contribution to a SEP IRA, even if this amount is later converted to a Roth IRA, is not in effect allowing you to exceed the $3,000 Roth contribution limit. The Roth IRA is a plan that is funded with after tax assets, by an individual taxpayer. The SEP (employer contribution) if funded by a business entity (including sole proprietorships), which takes a deduction for the SEP contributions it makes. Once the SEP employer contributions is deposited to the SEP IRA, it is treated as regular IRA assets, and will be treated as ordinary income for the year the assets are converted to the Roth IRA.

When choosing between two retirement plans…

…an individual taxpayer may decide between a Traditional and a Roth IRA…

…a business may decide between a SEP , a SIMPLE or a qualified plan ( e.g. 401(k), profit sharing etc.)

Note:Remember that you are not allowed to convert your IRA assets to a Roth IRA in any year that your Modified Adjusted Gross Income (MAGI) is more than $100,000 and/or if your are married and file a separate tax return from your spouse.

[Guest Hopewell]

Thank you for your quick reply. Just to be certain I understand, allow me to summarize what you said in somewhat different terms:

Although there’s no loophole here, you are confirming that my wife can invest in both types of IRA’s and then convert the SEP-IRA into her Roth IRA, all in the same year. And, although this would negate the tax benefits of that part of the SEP-IRA contribution that was converted, it would have the effect of allowing her to invest more than $3000 maximum ($3500 if 50 or over) to her Roth IRA in a given year?

[Appleby]

Just to be sure, let me summarize some points.

Yes. As long as he meets the eligibility requirements and have sufficient compensation/income, she may fund both plans.

Converting the amounts that are contributed to the IRA as SEP-Employer contributions does not negate the tax benefits (tax deductions for contributions made) an employer enjoys from funding a SEP.

Once the SEP Employer contributions is made to the SEP IRA. It assumes the identity of regular Traditional IRA assets.

These IRA assets, including other traditional IRA assets, may be converted to a Roth IRA at anytime for any year that your wife’s MAGI does not exceed $100,000. This $100,000 cap is the same for single filers as well as married individuals filing a joint tax return.

Assets converted to a Roth IRA may be taxed as ordinary income in the year the conversion is done.

There is no limit on the balance/value of Traditional IRA assets that may be converted to a Roth IRA. If your wife has a balance of $100,000,000+, she may convert this amount to a Roth IRA, providing she meets the income limit and does not file a separate tax return.

This means that you can fund a Roth IRA with an unlimited amount of funds/assets in any given year- as long as you meet the eligibility requirements.

The key benefits your wife would realize by converting the IRA assets to a Roth IRA is paying the taxes due now and for the earnings to accrue on a tax-free basis ( earnings are not taxed if distributions meet certain requirements)... as opposed to a Traditional IRA, where assets accrue on a tax-deferred basis.