Image Source: www.daveramseyfan.com

Congress has created (unintentionally, of course) a unique planning opportunity for those who want to contribute to a Roth IRA, but have incomes that are too high to do so.

In the past, there has been an income limit on both Roth IRA contributions and Roth conversions (moving traditional IRA assets to a Roth IRA.) However, in recent years Congress has lifted the Roth conversion income limit, while keeping the Roth contribution limits in place. This change has opened the door for a special strategy, colloquially known as the “backdoor Roth IRA.”

Walter Updegrave at Money Magazine describes how to do it:

Even if your income exceeds the Roth IRA income eligibility requirements — and I suggest you check out this calculator to verify whether that’s really the case — you can easily get around that hurdle: Simply open up a nondeductible IRA — which anyone under age 70½ with earned income can do — and then immediately convert the nondeductible IRA to a Roth IRA.

If you think you are going to be in this situation for the foreseeable future, then the simplest way to execute this strategy is to fund two years of non-deductible IRA contributions at the same time, and then do the conversion. You can do this any time from January to April 15, and obviously you would do last year and this year at one time. After you have documentation that the contributions were made and coded correctly (to the appropriate year), then convert the account to your Roth IRA. Then two years later, repeat the process.

Sounds easy, right? There is a rather important catch, however. If you have other IRAs with tax-deferred money in them, any Roth conversion will be treated as a pro-rata from all your IRA accounts. This is what is known as the “Coffee and the Cream” rule, which means that once the after tax contributions get added to your pre-tax IRA funds, the two mix together and cannot be separated–just like cream that gets added to a hot cup of coffee.

For example, let’s say you have previously rolled over $95k from your 401k into a separate IRA. All of the contributions to your 401k were pre-tax. Then you follow the strategy above to put $5k into a non-deductible IRA, and then convert to a Roth. Applying the Coffee and the Cream rule, the IRS will treat that conversion as 95% taxable, because they will look at all your IRAs together and determine that 95% of them are pre-tax.

For this reason, the Backdoor Roth strategy works best for those with no other IRA accounts.

As you can tell, while this strategy can seem straightforward, it’s easy to make a mistake. So, I would suggest you consult an educated tax and retirement specialist for help.

Happy tax planning!