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Setting Up A Roth IRA Through The ''Back Door''

Congress opened one door to Roth IRAs a few years ago by removing an annual income limit that had prevented many people from converting a traditional IRA to a Roth. Now you can make that switch regardless of how much you earn. But another door—for making annual contributions to a Roth—remains closed to many high income-earners.

Fortunately, there’s a way to enter through the “back door.” It requires a two-step strategy—first making nondeductible contributions to a traditional IRA, then converting that IRA to a Roth. The end result is the same as if you’d been able to make a straight Roth contribution.

Contributions to a traditional IRA may be partially or wholly deductible, depending on your modified adjusted gross income (MAGI) and whether you (or your spouse, if you’re married) participate in an employer-sponsored retirement plan. When you make withdrawals from those accounts, the portion of the distribution representing deductible contributions and earnings is taxed at ordinary income rates. After you’ve reached age 70½, you must begin taking “required minimum distributions” (RMDs) from the IRA.

In contrast, contributions to a Roth IRA are never tax-deductible. However, “qualified distributions” from a Roth are 100% tax-free. Qualified distributions include those made after age 59½, due to death or disability, or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). And with a Roth, there are no RMDs during your lifetime.

Switching to a Roth now could be particularly advantageous, considering that tax rates are scheduled to rise in 2013, unless Congress enacts new legislation. For instance, the top income tax rate of 35% will rise to 39.6%. Making a conversion to a tax-free Roth IRA this year—and paying income tax on the amount you convert at the current, lower rates—could provide significant savings.

Even now, however, the ability to make annual contributions to a Roth is phased out for high-income investors. The phase-out in 2012 occurs between $173,000 and $183,000 of MAGI for joint filers ($110,000 and $125,000 for single filers). But tax experts have devised a strategy to circumvent those limits.

You could start by setting up a traditional IRA funded with nondeductible contributions. (You probably won’t qualify for deductible contributions anyway.) Then you could convert the funds in the traditional IRA to a Roth. Because you’re not taxed on the amount representing nondeductible contributions, your tax liability should be little or nothing. And you can realize the future tax benefits of your Roth just as if you had made regular contributions.

Be aware, however, of one potential wrinkle in the rules. You can’t designate traditional IRA transfers as coming from one particular IRA. Any distribution from a traditional IRA is treated as being made on a pro rata basis from all your IRAs. That could create a bigger conversion tax than expected if you have several traditional IRAs.

For example, suppose you have $95,000 in an IRA that includes a rollover from a company 401(k) at a former job. In 2012, you contribute the maximum $5,000 to a traditional IRA on a nondeductible basis. (The annual limit for IRA contributions is $6,000 if you’re age 50 or over.) Then you transfer the entire $5,000 in the second IRA to a Roth IRA.

In this case, you could be in for a rude awakening. Because you have to take into account the total value of your two IRAs—$100,000—most of the amount you convert will still be taxed at ordinary income rates. Because the $5,000 IRA represents only 5% of the total amount in both IRAs, only 5% of the amount you convert—just $250—will be exempt from the conversion tax. You can’t avoid the tax hit just because you moved the funds out of the traditional IRA with the $5,000 of nondeductible contributions.

One solution to this problem is to use a “roll-in” instead of a rollover before you convert. In other words, first transfer the funds in your traditional IRAs consisting of taxable amounts (earnings and any deductible contributions) to your current 401(k) plan, assuming your plan permits that. When you’re ready to use the back-door method, you’ve reduced the taxable amount to the earnings from your nondeductible IRA. And as long as you don’t maintain any IRAs that have taxable contributions or earnings, you could use the back door approach annually to build up the balance in your Roth IRA without additional tax complications.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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