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Don't qualify for Roth? Use 'back door'

Those who earn too much to contribute to a Roth IRA can get the same benefits by opening a traditional IRA and converting it. Should you?

By MSN Money Partner Jan 27, 2012 7:01PM

This post is by Ashlea Ebeling of your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a back-door way.


Step 1: Open a traditional IRA (in your case, it’s nondeductible). Step 2: Convert it to a Roth IRA.


Is it worth it?


"It’s a no-brainer if you have the cash to do it," says Kevin Huston, an enrolled agent in Asheville, N.C. , who has clients young and old doing it to shore up their retirement savings. "It especially makes sense for people who are younger, because they have all these years of tax-free growth."


Basically, you get an extra $5,000 (or $6,000 if you’re 50 or older) each year that grows in the Roth IRA income-tax free. That’s $10,000 (or $12,000) a year for a married couple. Repeat each year, and you can amass a nice retirement kitty.

The audience for back-door Roths is a niche: those earning too much to contribute to Roths directly but not so much that the extra tax savings doesn’t seem worth the effort. Vanguard says that "backdoor Roth" contributions represented about 2% of traditional IRA contributions in 2011. Income restrictions on conversions were lifted starting Jan. 1, 2010, so anyone -- regardless of income -- can convert a traditional IRA to a Roth.


Why go through the hoops of getting money into a Roth IRA? They are an amazing deal, especially for folks looking long-term and expecting higher tax rates in the future. With a Roth IRA, you don’t ever have to take money out, and when you do start taking money out, it’s all tax-free income, including the earnings.


By contrast, with a traditional IRA, earnings grow tax-deferred, you have to start taking required mandatory distributions the year after you turn 70.5, and distributions count as income. A Roth can help keep your tax bite down in retirement. (Ideally you want a mix of taxable, tax-deferred and tax-free accounts to draw from in retirement.)


A Roth IRA also has other benefits. Medicare premiums are based on income, so by keeping your income down, you’ll pay a lower premium. If you leave a Roth account to a child, he or she will have to take money out each year, but there will be no income tax hit. (Inheriting a $100,000 Roth IRA is a whole lot better than inheriting a $100,000 traditional IRA; the higher your beneficiary’s tax bracket, the bigger the savings).


Here’s how the strategy can help a real couple in their 40s build their nest egg. The wife’s in marketing with a pharmaceutical company, and the husband is a stay-at-home dad. She’s maxing out on her company pre-tax 401k plan contributions -- putting away the full $17,000 for 2012. Her employer doesn’t offer a Roth 401k option. The couple told Huston, their tax adviser, they want to save more, but they can’t contribute to Roth IRAs directly because her income is nearly $200,000 a year. (Once your modified adjusted gross income is $183,000 for a couple filing jointly or $125,000 for singles, no Roth IRA contributions are allowed.)


But they can each contribute to a traditional IRA. They don’t get a deduction because of the wife’s high income, so it’s called a nondeductible IRA. She puts away $5,000, and he puts away $5,000. (His IRA is based on her earnings and called a nondeductible spousal IRA; otherwise you have to have earned income to contribute to an IRA.) Then they convert the IRAs into Roth IRAs.


That sounds complicated, but you can do all it online, and it’s almost as easy as transferring money from checking to savings. You pay income tax the next April only on any earnings accrued between the time you contributed to the nondeductible IRA and converted to a Roth.


There’s one big caveat to the back-door Roth: the pro rata rule. When you calculate the taxes due on a conversion, you have to take into account all your IRA assets, not just the new $5,000 nondeductible IRA. For example, if you have a traditional IRA with $95,000 of money from a 401k rollover (the $95,000 contributions were made on a pretax basis), and you make a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.


So when might it make sense to skip this whole exercise? Ronald Finkelstein, a CPA and lawyer with Marcum in Melville, N.Y., said he personally makes nondeductible IRA contributions each year and has considered doing a Roth conversion but passed because he has accumulated a large sum in a traditional IRA he opened 30 years ago when he had a newspaper route. Plus, he may retire to Florida, so paying the New York state tax bite wouldn’t make sense. "You have to do the calculations," he warns.


But sometimes it can still make sense even for older folks with big traditional IRAs. Another Huston client, a 68-year-old builder, does them as part of a holistic plan to get more of his net worth into tax-free accounts so he and his wife (and grandchildren) will have the accounts to tap as part of a tax diversification strategy. He just did a $6,000 back-door Roth for the third year in a row. At the end of each calendar year, Huston and the builder look at his income and decide how much to convert from his traditional IRA (one year it was $50,000; one year $25,000), keeping in mind what would push him into a higher tax bracket.


There’s still time to make an IRA contribution for calendar year 2011 through April 17, 2012. You can double up and make your 2012 contribution, too.


How long should you wait to convert? "It’s a gray area," says Robert Keebler, a CPA in Green Bay, Wis. He suggests a waiting period of six months, although other advisers say to convert the next day to limit the tax bite on the conversion.


More from and MSN Money:


Jan 30, 2012 1:32PM
Convert. You have a lifetime of tax savings.Smile
Feb 1, 2012 9:01PM

Great article.  Another advantage for those able to claim the Form 8880 credit...contribute to an IRA, lower your AGI, get a credit up to 50% of contributions made up to 4,000 on a joint return...example below:


Several years later, after 8880 is no longer a HUGE advantage convert that  accumulated IRA as long as effective tax rate is below 28%, you are paid - paid quite well to convert for future tax free retirement...


Young Al and Brenda have a 6 year old daughter they file a joint return

Al has 15,299 in wages

Brenda 16,000

  they got a nice refund last year of 1000 from child credit and EIC

they have 160 in dividends

they also (bear with me here) won a radio prize worth 2,800 and hit the slots for 3,700 this year - unlikely, but this is for effect - helps the EIC...


they decide to put last years refund to work in an IRA and also put 3000 into an IRA too - total 2000 each

AGI ends up being 33939

tax is 1108

  Form 8880 credit eats up the tax at 1108, 0 tax

  This year EIC 1152 refundable

  this year chilt tax credit 1000 refundable

    Nice start on next year's IRAs


rinse and repeat.

Feb 1, 2012 8:24AM
Another advantage of a Roth is that, after the initial 5 year waiting period, you can pull out the amount you paid without penalty or taxes to cover any sort of emergency.  (The reporting is screwy untill you hit 59 & 6 months but it works.)  Also, you are not forced to make withdrawals after you reach 70 & 6 months so you can continue to hold it as an emergency fund.
Jan 31, 2012 6:19PM
I don't understand why Mr. Keebler suggests waiting 6 months to convert.  What is the potential advantage of waiting over converting right away?
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