Entering a Roth via the Back Door

For some high-income taxpayers, the door to Roth IRA contributions has been slammed shut due to annual limits imposed by the tax law. But an innovative strategy can enable you to contribute to a Roth through “the back door.” Consider this technique as a means of building up your retirement nest egg.

Background: With a Roth IRA, you can never deduct annual contributions, unlike a traditional IRA. (Deductions for traditional IRAs are generally reduced or eliminated for taxpayers who participate in an employer-sponsored retirement plan). However, if a Roth has been in existence at least five years, “qualified distributions” are completely tax-free. For this purpose, a qualified distribution is one that is made after you have reached age 59½, paid on account of death or disability or used for first-time homebuyer expenses (up to a lifetime limit of $10,000).

In contrast, distributions from a traditional IRA are taxable at ordinary income rates, with a current top tax rate of 35% (scheduled to increase to 39.6% in 2013). Thus, depending on your situation, you might prefer to contribute to a Roth rather than a traditional IRA.

Note that you can now convert a traditional IRA to a Roth IRA regardless of your income level. Previously, a conversion was not allowed if your modified adjusted gross income (MAGI) for the year exceeded $100,000. This barrier was recently removed, beginning in 2010.

The contribution limit for both IRAs for 2012 is $5,000; $6,000 if you are age 50 or older. However, the ability to contribute to a Roth is phased out for certain high-income individuals. For 2012, the phaseout occurs between $173,000 and $183,000 of MAGI for joint filers; $110,000 and $125,000 of MAGI for single filers. If you exceed the high point of the phaseout range, no contributions are allowed for 2012.

Idea in action: To avoid the phaseout rule for contributions, you may set up a nondeductible IRA. In other words, you contribute to a traditional IRA, even though you don’t qualify for deductions or choose not to claim them. With a nondeductible IRA, only the earnings are subject to tax. Then you can convert the traditional IRA to a Roth, thereby entering the Roth through the back door.

For example, say you have contributed $10,000 to a traditional IRA and have earnings of $2,000. This is the only IRA you have, and you have not claimed any deductions. If you convert the nondeductible IRA to a Roth this year, you are taxed only on the $2,000 of earnings. After five years, any distributions are 100% tax-free.

There is, however, one other obstacle in your way. You cannot designate distributions as coming from a particular IRA. Any distribution from a traditional IRA is treated as coming out on a pro rata basis from all the IRAs you have. This could trigger a bigger conversion tax than expected, especially if you recently rolled over a distribution from a 401(k) or other company plan to a traditional IRA. To reduce the tax conversion impact, you might keep more funds in your plan account before using the back-door approach.

Does this back-door strategy make sense for you? There is no absolute “right” or “wrong” answer. It depends on your personal situation. Consult your professional advisers for guidance.