The Tax Man Cometh?
Your biggest expense in life is likely to be taxes. Roth IRAs can be a wonderful way to shield yourself from taxes and really build wealth. If you follow the rules, the dollars in a Roth IRA are never taxed again — not taxed on the investment earnings, and not even when you take the money out.
Sadly, many high income earners mistakenly believe that they are shut off from Roth IRAs on account of income limits. While it may be true you can earn too much to qualify for a direct Roth IRA contribution, you could always use what's become known as "the back door" by taking advantage of a process known as a Backdoor Roth IRA.
The Path to the Backdoor
The Backdoor Roth became a reality in 2010 when income limits on IRA conversions were lifted. In a nutshell, the process involves a one-two process of opening a traditional nondeductible IRA and then converting it to a Roth IRA. Voila, your Backdoor Roth IRA!
There's Always a Catch
There is sometimes a catch that comes into play and takes people off guard: the Pro-Rata Rule. When a traditional IRA is converted into a Roth IRA, the IRS runs a calculation to determine how much of the converted amount will be considered pre-tax and how much post-tax. In this calculation, the IRS treats all your traditional IRAs as one big IRA account (including SEP and SIMPLE IRAs, too). Here's a formula to figure out how much of amount destined for your Roth IRA will end up as taxable income on your tax return: