The Secret Backdoor to Contributing to a Roth IRA

I know who you are; you glaze over in boredom at the dumb and dumber breathless reporting in Finance 101 world. You know the preachy wisdom - maximize your 401K, reduce your credit card debt etc. Please - you graduated grade school a while ago.

You've slobbered over the much-touted benefits of the Roth IRA, you know, the ability to take out your contributions penalty-free at any time, the tax-free (as opposed to tax-deferred) earnings, no minimum distributions and all that jazz. But you don't qualify - you make too much money to meet the IRS guidelines. Contribution phaseouts for Roth IRAs begin at $105,000 (single filer) or $166,000 (married filing jointly) for 2010.

New rules beginning in 2010 could just give you a backdoor to contributing to a Roth, read on...

Taking advantage of the new tax laws in 2010

Starting in 2010, new rules allow you to convert your holdings from a Traditional IRA to a Roth, with no income limits. Formerly, only taxpayers with Modified Adjusted Gross Incomes (MAGI) of $100,000 or lower were eligible for this strategy.

How can you leverage this? Say you've been diligently contributing to a traditional IRA (up to $5000 per year) - you can now roll over these contributions into a Roth IRA. Not only that, since there are no limits on how much you can rollover, and how often, you can use this technique to fund your Roth IRA. Presuming Congress doesn't slam the door, you can do this every year: i.e. fund your traditional IRA with $5000/year ($6000 if you're eligible for catch-up contributions), and then roll it over into a Roth. Presto, you're now effectively contributing annually to a Roth IRA, even though you may be over the income limit.

Uncle Sam's Pound of Flesh

So here starts the fine print section (you knew it was coming). There are two potential tax consequences that you may be hit with in Roth IRA conversions:

1) If you have deductible (or pre-tax) Traditional IRA contributions that you're rolling over, these will be subject to income tax. Say you roll over $100 in pre-tax contributions, and your tax bracket is 28%, you will owe $28 to the iRS.

2) Gains on your Traditional IRA contributions are subject to income tax as well. Let's say your traditional IRA contributions of $100 gained 10% or $10. When you convert into a Roth IRA, the gains ($10) would be subject to income tax as well.

Consult your tax professional to understand the implications for your personal situation. Note that even if you have multiple IRA accounts, funded with some pre-tax and some post-tax dollars, you will not be able to convert just the post-tax (nondeductible) IRA accounts.

Who's home scot-free?

Don't have any pre-tax traditional IRA contributions, and love the Roth benefits? This could be a terrific strategy for you.

Confused? Leave me a comment, and I'll respond to your situation (not a substitute for professional advice).

Bottom Line: You can roll over your contributions from a Traditional to a Roth IRA. Since there is no limit to the number of times you can do this, you can use this technique as a way to contribute to your Roth IRA, even if you are over the income limit for contributions.