Tax-Free Income for All

High-income households have always been shut out of Roth IRAs. But a recent change in the tax law lets you get into a Roth -- and enjoy the benefits of tax-free retirement income -- through the back door.

Under current law, you can't contribute to a Roth if you are single and have an income of more than $110,000, or married with a joint income in excess of $160,000. The new law, which goes into effect in 2010, does not alter the income limits for Roth IRA contributions. But it does eliminate the $100,000 income limit for converting a traditional IRA to a Roth. You must pay income taxes at your top rate on the total amount you convert to a Roth -- that's the price you pay to make all withdrawals tax-free in retirement. To encourage conversions, which will bolster U.S. Treasury coffers in the short run and save you loads on taxes over time, Congress says that folks who convert in 2010 can spread the tab over 2011 and 2012.

By opening the back door to Roth conversions for everyone, Congress effectively wiped out the limit on pay-ins, too. And high-income taxpayers can waltz through the door right away. Starting in 2006, you can contribute $4,000 a year to a nondeductible traditional IRA, or $5,000 if you are 50 or older. (The limits rise to $5,000 and $6,000 in 2008.) In January 2010, when the income limits disappear, you can convert the traditional IRA to a Roth IRA and owe tax only on the earnings.

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Let's say you're over 50 and stash $28,000 in a nondeductible IRA during the next five years. Let's further assume your account is worth $32,000 by 2010. When you convert that IRA to a Roth, you'd owe taxes only on the $4,000 in earnings. So the price of admission to the Roth would be just $1,120, assuming you're in the 28% tax bracket. You'd pay half the bill in 2012, when you file your 2011 return, and the rest in 2013. If you're married, both you and your spouse could use this strategy to create substantial Roths, even if one spouse does not have any earned income.

In addition to providing tax-free income in retirement, Roth IRAs are a valuable estate-planning tool. Unlike traditional IRAs, which require you to start withdrawals at 70#189;, Roths have no mandatory distribution age. And your heirs can inherit a Roth tax-free.