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Backdoor into the Roth IRA: You’re Invited to the Tax-Free Party

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Have you ever been waiting in a long line somewhere wishing you knew somebody that could get you in the backdoor? Or hoping that somehow you were the VIP and had immediate access to the hippest party around? When it comes to the Roth IRA in 2010, everybody becomes a VIP and gets a chance to enjoy the “tax-free” party at retirement!

I know what you’re thinking: what’s so cool about the Roth IRA? Look at it this way. If having to pay taxes is “un-cool,” then tax free money should be the coolest thing around — and that my friend is the Roth IRA. Unfortunately, not everyone has been able to enjoy the Roth. Higher wage earners have been left on the outside looking in, chomping at the bit to get a piece of the “tax-free” pie. In 2010, they will finally get their slice.

Roth IRA Conversion

Jason from Redeemming Riches did an excellent job highlighting the opportunity that 2010 presents for the Roth IRA. The Roth IRA Conversion is an awesome opportunity for many to finally get some of their old IRAs and 401ks into the Roth. One piece of info that Jason did not touch upon is that while you’ll be able to convert to a Roth IRA even if you’re a higher wage earner, what about adding new money? Are you once again left out in the dark?

Many people have wanted to take advantage of the Roth IRA for the past several years, but couldn ’t because they surpassed the Roth IRA phaseout limits. Many then settled for the pretax substitute of the traditional IRA. The only problem with the traditional IRA (other than paying taxes at retirement) is that after certain income limits you no longer get a tax deduction for contributing to one. You still get the tax deferred growth, but that ’s it. Not even near as cool as the Roth IRA.

If you are an active participant (making annual additions or accruing a benefit) in a company retirement plan (think 401k) and make more than $65,000 as a single taxpayer in 2010 (or $109,000 as a married joint taxpayer) then you are disqualified from taking the full deduction. What you are then left with is the nondeductible IRA.

Introducing the Nondeductible IRA

In the past, there was nothing all that attractive about the nondeductible IRA. You did get tax deferral, but no immediate tax deduction and you still had to pay tax at retirement. With 2010 just around the corner here, the nondeductible IRA has become a very popular tool to allow high wage earners a way into the Roth IRA — a “backdoor” way. A high wage earner can contribute to a nondeductible IRA with the sole intentions of converting it in 2010 to Roth IRA. Wait, did you catch that? Stated differently, if you are not eligible to contribute new money into a Roth IRA in 2010, you can open up a traditional non-deductible IRA and immediately convert it to a Roth. As I said, everyone is a VIP now!

By contributing to the nondeductible IRA, you will only be responsible to pay what gains you ’ll have from now until you convert in 2010. If 2009 will be the first year to contribute (you still have until April 15th to open a Roth IRA and make the 2009 contribution), then, unless you happen to pick a one in a million shot, your tax liability should be minimized.

Other Things to Consider

If you are considering doing this in 2010, remember that the IRS looks at all your IRA’s together (all traditional and non-deductible) and will compute the tax on the conversion collectively. Let’s look at a quick example:

Mary has an existing traditional IRA of $10,000, which she has only contributed $4,000 to. She now makes too much for a Roth and wants to use the backdoor nondeductble IRA we’ve discussed. When she contributes $5,000 to the IRA and immediately converts, she will have to add $10,000 to her income (67% of $15,000) instead of just the $5,000 of the IRA that maybe she was expecting.

It Can Get Complicated

As you can see, the Roth IRA conversion can get a little tricky. Be sure to weigh all your options before you pull the trigger. If you need more clarification, check out this step by step guide on the Roth IRA conversion tax rules. Be sure to consult with your tax advisor before implementing this strategy.

*Restrictions, penalties and taxes may apply. Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

 

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