Sunday, August 19, 2012

The backdoor Roth IRA

If one's income exceeds the limits for contributing to a Roth IRA, there's still a backdoor approach for making a contribution.  The method, outlined in this article by Fidelity, shows that one can contribute to a non-deductible IRA (which has no income limit), and immediately convert that to a Roth IRA (which also does not have any income limits).

That catch here is that one must not have any other IRA -- Traditional or Rollover.  Otherwise, that will complicate tax matters since the tax liability is calculated as a percentage of all funds that are eligible for rollover.  If one has a Rollover IRA, usually from rolling over funds from 401(k) plans at previous employers, then to get the most benefit out of this, one would have to roll over the funds from the Rollover IRA into the current employer's 401(k) plan.  Most 401(k) plans allow that.  The down side to such a roll over is that, unlike an IRA at a traditional brokerage which typically has nearly limitless investment options, one would be restricted to the investment choices offered by the current 401(k) plan.

Useful reading
Disclaimer: I am neither an investment advisor nor a tax preparer.  If you think this applies to you, please do your own homework to decide whether it works for your situation.  Otherwise, it can land you in a tax mess.  At the very least, it is a bit more paperwork since it requires filing IRS form 8606 which will show the contribution to the non-deductible IRA, the conversion to the Roth, and report that there are no other IRA funds.  Here is an article warning about some of gotchas to watch out for.

Update 3/21/2016

I recently came across an article which throws another wrench in the works--the Step Transaction Doctrine.  Read the article for details.  This article is the subject of a heated discussion over at Bogleheads.