The Backdoor Roth IRA

Next year offers upper-income taxpayers a one-time chance to get in on the benefits of a Roth IRA. One of the major advantages of a Roth IRA is that earnings aren’t taxable when you take them out. That feature could be especially valuable to taxpayers with higher incomes, but the tax law has some built-in barriers that prevent them from contributing or converting to a Roth. Back when the law creating Roth IRAs was written, Congress put income limits on Roth contributions and conversions. Taxpayers who file jointly and have an Adjusted Gross Income (AGI) of more than $166,000 ($105,000 for single filers) can’t contribute to a Roth and those with an AGI of more than $100,000 are barred from converting a traditional IRA to a Roth.

But the tax law that was passed in 2006 opened a window for these higher-income taxpayers. In 2010, and for that year only, anyone can convert a traditional IRA to a Roth, no matter how high his or her income is. There are still some tax impacts to think about, however. If your traditional IRA was funded with pre-tax money, for example, you’ll have to pay taxes on the entire amount of the conversion. You can ease the tax burden, however, by splitting the amount of the conversion, reporting half on your 2011 tax return and the rest on your 2012 return.

If your IRA is funded with after-tax dollars, on the other hand, you pay taxes only on the earnings, not the contributions you’ve made. That leads some tax experts to advise upper income taxpayers to take advantage of next year’s Roth conversion rule by opening a non-deductible traditional IRA now and converting it to a Roth next year. By doing so, the taxpayer gains all the advantages of a Roth and pays taxes only on any earnings in the IRA.