Although one barrier for Roth IRAs has been removed, another exists for certain taxpayers: You can’t make annual contributions to a Roth if your income is too high. But there’s a clever way to get around this obstacle.
Strategy: Go in through the “back door.” You can do it by making nondeductible contributions to a traditional IRA and then converting the traditional IRA into a Roth IRA.
The maximum annual amount you’re allowed to contribute to your IRAs, including any combination of traditional and Roth, is limited to $5,000 for 2012 ($6,000 if you’re age 50 or older as of Dec. 31, 2012). But there’s nothing to prevent you from using the back-door approach each year.
Here’s the whole story: With a Roth IRA at least five years old, distributions are completely exempt from income tax if you are over age 59½.
In contrast, distributions from a traditional IRA may be fully taxable at ordinary income rates reaching up to 35%. So you might be encouraged to convert a traditional IRA to a Roth before retirement, even though you’ll be hit with taxes on the conversion.
Under prior law, you could not convert to a Roth in a year in which your modified adjusted gross income (MAGI) exceeded $100,000. Beginning in 2010, this restriction no longer applies. However, the ability to contribute to a Roth is still phased out for high-income individuals. The phaseout in 2012 occurs between $173,000 and $183,000 of MAGI for joint filers ($110,000 and $125,000 of MAGI for single filers).
Build up nondeductible IRAs
To avoid the contribution phaseout rule, you can set up a nondeductible IRA. (Deductions to a traditional IRA are not available for high-income taxpayers if you participate in an employer retirement plan.) If your only traditional IRA is a nondeductible IRA, only the earnings are taxable when you convert the account IRA into a Roth IRA.
Caution: You can’t designate distributions as coming from a particular IRA. Any distribution from a traditional IRA is treated as coming on a pro rata basis from all of your IRAs. That could mean a much bigger conversion tax than you expect.
Typically, this is a problem if you recently rolled over a payout from a 401(k) plan or other company plan.
Example: You contribute $6,000 to a nondeductible IRA each year for five years before you retire. The contributions earn 8% annually, so the account balance will be worth $38,016 after five years. If you have no other IRAs, you’re taxed only on the $8,016 of earnings ($38,016 minus $30,000 in contributions).
However, if you have another IRA representing a rollover from a 401(k) and earnings, your tax bill will be much higher. Suppose the total value of your two IRAs is $300,000. In that case, you’re taxed on 90% of the value of whatever you convert ($270,000 of combined earnings/$300,000 combined account value = 90%).
Roll with the punches
One possible way to avoid the sting of the pro rata rule is to use a “roll-in” instead of a rollover before a conversion. In other words, first transfer the funds in your traditional IRAs consisting of taxable amounts (earnings and any deductible contributions) to your 401(k), assuming the plan permits it. Therefore, once you’re ready to use the back-door Roth, you’ve reduced the taxable amount to the earnings from your nondeductible IRA.
Tip: Crunch all the numbers to see if a back-door Roth makes sense for your situation.
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