A Roth IRA through the back door

A couple would like to add to their granddaughter's Roth IRA, but she's no longer eligible. Where there's a will, Money Magazine's Walter Updegrave has a way.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: Our granddaughter fully funds her 401(k). But to give her an incentive to save even more, we give her $2,000 a year to invest in a Roth IRA, provided she invests $2,000 of her own money first. She recently married, however, and now her and her spouse's combined income make her ineligible to fund a Roth. We'd like to continue our matching-fund arrangement with a non-deductible IRA. Is that possible? - Lauri Shafer

Answer: Sure. Almost anyone with earned income can open a nondeductible IRA. Your granddaughter can contribute up to $4,000 this year and $5,000 next year. (People 50 and older can throw in an extra $1,000.) There's no cap on how much one can earn and still contribute.

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The only requirement is that the account owner (or that person's spouse) have compensation income at least equal to the amount being contributed. So a married couple would need compensation income of $8,000 or more to contribute $4,000 apiece to nondeductible IRAs.

In short, there's nothing to prevent you from giving your granddaughter a matching contribution that she can invest in a nondeductible IRA. The real question is should your granddaughter (or anyone else, for that matter) bother with a nondeductible IRA?

Until recently, I would probably have said no. The reason: since there's no tax deduction for a contribution to a nondeductible IRA, all you're really getting is tax-deferral on investment gains. That's valuable. But you can effectively get that by investing in tax-efficient investments such as tax-managed funds, index funds or ETFs within a taxable account.

And if you hold those investments longer than a year, a very large portion of your gains will be taxed at the long-term capital gains rate, which maxes out at 15 percent. Gains in the nondeductible IRA, by contrast, are taxed at ordinary income rates, which can go as high as 35 percent.

Given this less favorable tax treatment, I've never been a big fan of nondeductible IRAs. But thanks to Congress (three words I don't often get to use in a positive way), funding a nondeductible IRA can be a good deal. Not because something has fundamentally changed about nondeductible IRAs. Rather, it's because they can now be used as a back-end way for high-income people to invest into a Roth IRA and get a shot at tax-free withdrawals in the future.

Let me explain. Last year, Congress passed legislation that, among other things, eliminated a restriction barring anyone with modified adjusted gross income over $100,000 from converting a traditional IRA (whether deductible or nondeductible) to a Roth IRA.

This new provision doesn't go into effect until 2010. But starting in that year, anyone who has a traditional deductible or nondeductible IRA will be able to convert it to a Roth. The income eligibility rules that prevent your granddaughter from making an annual contribution to a Roth will still apply.

But there's an easy way around them: Just open a nondeductible IRA and then convert it to a Roth. So with your help your granddaughter can fund a nondeductible IRA in 2007, 2008, 2009 and 2010 and then convert that account to a Roth in 2010. In subsequent years, your granddaughter can simply fund a nondeductible IRA and immediately convert it to a Roth.

Of course, if her income changes so that she's eligible to make an annual Roth contribution - or if Congress has another good idea and streamlines the Roth rules so people don't have to go through this ridiculous nondeductible IRA-to-Roth IRA charade - then she can fund the Roth directly in later years.

There is one caveat to keep in mind when making the switch to a Roth. When you convert, you owe tax on any dollars in the IRA that haven't already been taxed - which is basically everything except after-tax contributions, which includes nondeductible contributions to an IRA and after-tax contributions to a 401(k), if you made such contributions and then subsequently rolled the money into an IRA.

Not surprisingly, many people who have money in both deductible and nondeductible IRAs and are considering converting think, "Hmm, I'll just pull out my nondeductible, or after-tax, contributions and move them to the Roth. Since that money has already been taxed, I won't have to pay any tax on the conversion." Nice try, but the IRS won't let you get away with that ploy.

When you convert, you have to look at all the money in all the non-Roth IRAs you own - that is, deductible, nondeductible and rollover IRAs. You must then figure out how much of your total balance for all those accounts consists of money on which no tax is owed (nondeductible and/or after-tax contributions) versus money that has yet to be taxed (deductible contributions, pre-tax contributions and all earnings). Whatever the proportion of untaxed-to-taxed money is in your IRA accounts overall, the same ratio applies to the money you're converting.

So let's say you have $50,000 in all your IRAs and let's further assume that $40,000 (or 80 percent of the total) is in deductible contributions and earnings, while the remaining $10,000 (or 20 percent) is nondeductible contributions. If you were to convert $25,000 to a Roth, then no matter which IRA or IRAs you take the money from, $20,000 (80 percent of the conversion amount) would be subject to tax, while the remaining $5,000 (20 percent of $25,000) would go untaxed.

If you were to convert the whole shebang, then you don't need to calculate any percentages. All the $40,000 in earnings and deductible contributions would be taxed and the remaining ten grand would go untaxed.

Bottom line: As long as you're so inclined, you can continue your matching-funds program with your granddaughter, explaining that she should open a nondeductible IRA and then convert the money to a Roth starting in 2010. And as long as her income remains too high to make direct annual contributions to a Roth IRA, she can continue to do the end-run of funding a nondeductible IRA and then immediately converting it to a Roth.

You might also tell your granddaughter that, aside from the inherent attractiveness of the Roth's tax-free withdrawals, adding a Roth complement to her 401(k) is a good idea because it allows her to diversify the tax exposure of her retirement savings and give her more flexibility for managing withdrawals in retirement. (For more on this concept of tax diversification, click here.)

One final note: I hope other grandparents and parents out there who have the financial wherewithal to do so will consider adopting your excellent incentive system to induce their kids and grandkids to save more.

Explaining the benefits of saving for retirement is one thing. But I've always found that cold hard cash more convincing than mere words. Top of page