A new way to save tax-free

May 16, 2011: 12:33 PM ET
A new way to save tax-free with a Roth IRA

FORTUNE -- Amid all the rancor in Washington over how to rein in the federal deficit, one thing seems inevitable: If you're a six-figure earner, your tax bill has nowhere to go but up. The good news? A quirk in the tax code gives you a new backdoor opportunity to build your savings and shelter more of your income from the threat of higher taxes.

The opportunity lies with the Roth IRA, a tax-sheltered savings plan previously off-limits to high-income investors. Affluent savers have been confined to traditional IRAs, where contributions are sometimes deductible, and investment gains compound tax-deferred. But future withdrawals are taxed as ordinary income -- not an attractive prospect if tax rates rise. With a Roth IRA, on the other hand, contributions are made with after-tax dollars, but all future gains and withdrawals are 100% tax-free in retirement. You can contribute up to $5,000 a year (or $6,000 if age 50 or older) to a Roth, but only if your income falls below a certain threshold.

Last year Congress handed a break to high-income earners when it changed the tax code to allow anyone, regardless of income, to convert money already sitting in a traditional IRA to the Roth version. Prior to 2010, Roth conversions were allowed only for single or married taxpayers with modified adjusted gross incomes below $100,000. There's no dollar limit on the amount of traditional IRAs you can convert. But you'll have to pay taxes on any contributions or investment gains that had been tax-deferred to that point.

Kept in place were the income limits designed to stop affluent taxpayers from funneling new money into Roths. For 2011, single tax filers can make only the maximum Roth IRA contribution if their modified adjusted gross income is less than $107,000; once their income hits $122,000, they can't contribute at all. For married couples filing jointly, allowable contributions begin to phase out when their combined income reaches $169,000.

Inexplicably, Congress left a major loophole in the new tax code. No matter what your income, you're eligible to open a traditional, nondeductible IRA, which you can then convert to a Roth now that the income limits on conversions have been lifted. And you can repeat the process each year as long as the loophole is in place. "It's almost certainly an unintended consequence of the new rules," says Ed Slott, a CPA and IRA specialist in Rockville Centre, N.Y. "But it's a perfectly legal maneuver and a great strategy for high-income investors."

Before making this move, however, you should consider converting any existing traditional IRAs you have to a Roth or move them into your 401(k) plan if allowed, says Loyd Stegent, a Houston-based CPA at Cornelius Stegent & Price. Otherwise the IRS may hit you with a tax bill on a portion of your backdoor Roth contribution. (Ask your financial planner or visit IRS.gov to determine how that applies to you.)

You have until April 17, 2012, to make your nondeductible IRA contribution for 2011 before flipping it to a Roth. After that? Whether Congress will ultimately close the Roth loophole is anyone's guess. But given a chance to put money in an account that's tax-free for life, don't wait to find out.

--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.  To top of page

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