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The sneaky but probably legal way rich people shield retirement savings from taxes

Karol Franks

An individual retirement account (IRA) helps people shield their retirement savings from the tax man. It's especially useful for people who don't have access to an employer-sponsored 401(k) retirement plan, as well as for people who are rich enough to contribute the legal 401(k) maximum — currently $18,000 per year — and still have savings left over.

However, if you're a high earner trying to squirrel away extra cash in an IRA, you're likely to run into a big roadblock: IRAs have maximum income limits. The details are a little bit complicated (I'll explain more below), but in a nutshell if you make more than $132,000 — or more than $194,000 if you're part of a couple — you can't contribute directly to one type of IRA (called a Roth IRA) and lose a crucial tax deduction for the other type.

Presumably, Congress felt that a family making $200,000 per year was going to do fine without extra help from the tax code. But in 2005, Congress created a loophole that made these income limits effectively toothless. It's called a backdoor Roth IRA, and it provides high-income Americans with a sneaky but almost certainly legal way to save an extra $5,500 per year without paying taxes on their earnings.

Rich people aren't eligible for key retirement tax breaks

A traditional IRA is like a 401(k) plan you can sign up for without help from an employer. You don't have to pay income taxes on money you contribute to your IRA, and money in the account grows tax-free. You only have to pay taxes when you start withdrawing money from the IRA during your retirement years.

The Roth IRA flips the traditional IRA on its head: You pay taxes on money you contribute to the IRA, but earnings and withdrawals are tax-free.

This is an either-or choice. In any given year, you can contribute $5,500 to a traditional IRA or a Roth IRA, but not both. Which one you should choose depends primarily on whether you expect to be in a higher tax bracket in retirement than you're in now. If you think your tax rate is going to go up, you should pick a Roth IRA; otherwise, contribute to a traditional account.

Things get more complicated as your income goes up. If you make more than $71,000 ($118,000 for married couples filing joint tax returns), you lose the ability to deduct IRA contributions from income taxes. With the biggest tax advantage of traditional IRAs eliminated, most households above this cutoff are better off investing in a Roth IRA instead.

But then when a worker's income reaches $132,000 ($194,000 for couples), she loses the ability to make Roth IRA contributions. Until 2010, people too rich to contribute to a Roth IRA just had to live with getting a smaller tax benefit from a traditional IRA. They got no tax deduction for contributing to the IRA, but there was still some benefit to being able to defer taxes on capital gains and dividends.

Congress opens the back door

In 2005, Congress passed legislation that — once it took effect for the 2010 tax year — made the nominal limits on Roth contributions practically irrelevant.

You can convert a traditional IRA into a Roth IRA, but prior to 2010 you could only do this if your income was below $100,000. But then Congress eliminated that income limit, allowing anyone to convert traditional IRA money into Roth IRA money.

If a traditional IRA contains pre-tax money (e.g., the account owner took a tax deduction when he made the contribution), then the account owner has to pay income taxes when he converts the money to a Roth IRA. But wealthy taxpayers don't get an IRA tax deduction in the first place; they have to contribute to traditional IRAs with after-tax money. So when they convert a traditional IRA to a Roth IRA, they only owe taxes on the earnings — which will be small if the money was only in a traditional IRA for a short period of time.

So the backdoor Roth technique provides a two-step way for rich people to get money into a Roth IRA without running afoul of income limit. First, contribute money to a traditional IRA. Then convert the account to a Roth IRA.

A backdoor Roth is tricky if you already have money in traditional IRAs

I asked Jeff Levine, an IRA expert at the advising firm Ed Slott and Company, if there were any pitfalls people should watch for when making a backdoor Roth contribution.

The biggest pitfall, he told me, occurs if you already have a traditional IRA with pre-tax money in it.

"Let's say you have a $45,000 IRA account at one institution," Levine said, and that this money came from tax-deductible contributions at a time when your income was lower. Then you get a big raise that makes you ineligible for the IRA tax deduction. So "you decide to open a brand new IRA at a second institution and make a $5,000, non-deductible contribution."

You might think you can convert the $5,000 traditional IRA into a Roth IRA tax-free, since the contribution wasn't tax-deductible in the first place. But that's not how it works. The IRS treats your IRA money as if it all comes from one big bucket — as if you have a single $50,000 IRA — and treats conversions as if they drew proportionally from all of your IRAs.

In this case, since 90 percent of your total IRA funds are pre-tax and 10 percent of the money is after-tax, any Roth conversion will be 90 percent taxable and 10 percent tax-free. If you converted $5,000, you'd have to pay taxes on $4,500 of it, while only the remaining $500 would be treated as a tax-free conversion.

If you're in this situation, you have a couple of options. The best option is if you have a 401(k) plan at work that accepts incoming IRA rollovers. Then you can transfer all of your pre-tax IRA money into your work retirement account before doing a backdoor Roth conversion. Money in a 401(k) plan isn't counted when the IRS applies these IRA aggregation rules. (Click here for a detailed explanation of this strategy.)

If you don't have access to a 401(k) plan that will accept your pre-tax IRA money, then you may have to just bite the bullet and convert all of your traditional IRA money into a Roth IRA. Of course, if you have a lot of pre-tax money in IRAs, this could mean a huge tax bill. But if you expect your income to be above the Roth contribution limits for the foreseeable future, it might be worth it.

The conversion has tax benefits in its own right, since it'll save you from paying even more in taxes once you reach retirement age. And once you've done this conversion once, you'll be able to take advantage of backdoor Roth contributions every year.

Backdoor Roth contributions are (probably) totally legal

A few investment experts, notably blogger Michael Kitces, have claimed that the backdoor Roth technique could get you into hot water with the IRS. The issue is a rule called the step transaction doctrine, which says that taxpayers can get into trouble if they take a sequence of otherwise legal transactions that produce an illegal result.

But Levine disagrees. "I don't have any concerns about that whatsoever," he told me, and he says he uses the technique himself.

Over the past few years, the backdoor Roth technique has become increasingly mainstream. Vanguard, one of the nation's largest mutual fund companies, has a page on its website advising clients on how to make backdoor Roth contributions with no caveat about possible legal complications. According to Vanguard's data, about 20,000 Vanguard customers made backdoor Roth contributions for the 2013 tax year, and there's no sign that any of them got into trouble for it.

If you are concerned about the fairly remote possibility that the IRS might someday start cracking down on backdoor Roth contributions, skeptics like Kitces recommend introducing a delay between the time you make the initial IRA contribution and the time you convert the money to a Roth. The longer the delay between the two steps, the harder it is for the IRS to argue that they should be regarded as a single transaction for tax purposes. A one-year delay is the safest option, but a delay of a week or a month could theoretically prove beneficial as well.

But Levine believes a year-long delay is overkill — and it means paying taxes on earnings accumulated while the money was in the traditional IRA. Levine has never heard of anyone getting into trouble for using the technique, and he notes that the IRS itself has signaled that it doesn't believe a delay is required to make the technique kosher.

One final sign that backdoor contributions are legal, Levine argues, is that the Obama administration keeps asking Congress to make them illegal. That suggests the administration believes they're currently legal. Otherwise, Obama wouldn't need Congress's help here — he could just ask the IRS to start cracking down on the practice.

And Obama has a point. Whether or not you think rich people deserve larger retirement tax breaks, the current policy makes no sense. Either rich people should be allowed to contribute to Roth IRAs or they shouldn't be — but it makes no sense to require them to go through an awkward two-step procedure to benefit from the Roth IRA's tax breaks.