Q. My income is too high to contribute to either a deductible IRA or a Roth IRA. So am I better off investing in a nondeductible IRA or should I just invest my money in a regular taxable account? — Dennis, Cranston, R.I.
A. You’re giving up on the Roth IRA too easily.
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 avail yourself of this option — colloquially known as a backdoor Roth IRA — before April 15th, you can make the contribution for the 2012 tax year. By doing that, you’ll still preserve the option of making a contribution for 2013 as well.
The maximum contribution for 2012 is $5,000 ($6,000 if you’re 50 or older), while the limit for 2013 is $5,500 ($6,500 if you’re 50 or older). So if you contribute for both years, you can get quite a nice sum into that Roth this year: as much $10,500 if you’re under 50, $12,500 otherwise.
Keep in mind that whenever you convert funds to a Roth, you must pay income tax on any portion of the converted amount that has yet to be taxed. This isn’t likely to be much of an issue if the only IRA you own is the nondeductible IRA you open and then convert.
After all, you made your contribution in after-tax dollars, so those funds won’t be taxed again. The only tax bill you would incur is on investment gains, if any, that accumulate in your nondeductible IRA between the time you opened it and the conversion.
But if you also have money in other non-Roth IRAs — say, traditional deductible or nondeductible IRAs you opened years ago or a rollover IRA that holds money from a 401(k) with a previous employer — then you’ve got to consider the balances in those accounts when figuring the tax on the conversion.
For example, if you have $45,000 in an IRA rollover that consists totally of pre-tax dollars and you contribute $5,000 to a nondeductible IRA that you plan to convert, 90% ($45,000 in pretax dollars divided by your total IRA balance of $50,000), or $4,500, of your $5,000 conversion would be taxable. If your nondeductible IRA had investment earnings, those untaxed gains would have to be included in the calculation as well.
So if you were in, say, the 33% tax bracket, you would owe $1,485 in taxes on the conversion, which means you would effectively have to come up with $6,485 to get $5,000 into a Roth IRA.
But if you’re in this position — that is, you already have money in non-Roth IRAs andwant to get money into a Roth IRA but earn too much — there are two other maneuvers you may want to consider.
If you have a 401(k) plan through work and it accepts IRA rollover money (as most do) you could roll your IRA funds into the 401(k) and then convert your nondeductible IRA. Since you would have no other IRA money, you could convert your nondeductible IRA and avoid taxes (assuming your nondeductible IRA had no investment gains).
The other move you might consider is taking the money that you would have contributed to the nondeductible IRA and paid in taxes to convert that account ($6,485 in the example above) and use those funds to pay the tax to convert as much of the money in any existing IRAs as possible.
This would allow you to get more dough into a Roth than you could via the backdoor method, or nearly $20,000 assuming a 33% tax rate.
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If you choose this last route, don’t forget that any pretax dollars you convert are considered taxable income. So moving more money into a Roth could push you into a higher tax bracket and boost your conversion tax bill.
Remember too that converting IRA funds to a Roth IRA—or contributing to a Roth IRA, for that matter—usually makes the most sense if you think you’ll face the same or higher tax rate when you withdraw the money as you did when converting.
That said, unless you’re absolutely sure you’ll face a lower tax rate in retirement, I think it’s a good idea to have at least some money in a Roth account if only to diversify your tax exposure.
Bottom line: if you would really rather invest money in a Roth IRA than a nondeductible IRA or a taxable account, you can easily do so. Okay, maybe “easily” is going too far. But you should definitely be able to pull it off.