Roth IRAs -- Via the Backdoor

Let's face it, it's a nice problem to have: Your income is so high that you don't qualify to make regular annual contributions to a Roth Individual Retirement Account. In 2012, you can't fully fund a Roth if you're single and your modified adjusted gross income is more than $110,000, while the threshold for married couples filing jointly is $173,000. Your ability to contribute phases out above these income limits.

What to do? Here's a strategy that's popular with IRA experts and that you might discuss with your tax advisor: You could stash your $5,000 annual contribution--or $6,000 if you're age 50 or older--in a nondeductible IRA, and then immediately turn around and convert your nondeductible IRA to a Roth. Once the money is in a Roth, it can grow tax-free thereafter.

This financial maneuver would make your tax return a little more complicated. It would also trigger a small tax bill if your $5,000 or $6,000 notched any sort of gain between the day you funded the nondeductible IRA and the day you converted to the Roth. You wouldn't, however, owe any taxes on the $5,000 or $6,000 itself because it was a nondeductible contribution and hence the money had already been taxed.

But there's a much bigger caveat to bear in mind: For tax purposes, when you convert to a Roth, you can't designate which IRA you are converting. This isn't an issue if your nondeductible IRA is your only IRA.

But let's say you have a $5,000 nondeductible IRA and $100,000 in a traditional IRA that was fully funded with tax-deductible contributions, and you decide to convert $5,000 to a Roth IRA. You would have to assume the money converted comes pro-rata from your $105,000 total IRA. Result: Almost all of the $5,000 would be taxable--and the backdoor strategy wouldn't be nearly so appealing.

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