Background
Roth IRAs are tax advantaged retirement saving accounts. Contributions to Roth IRA accounts are NOT deductible. However, any earnings on the contributions can be withdrawn TAX FREE once the taxpayer reaches age 59 1/2 and it has been at least 5 years since the first year of Roth IRA contributions.
Example: Beginning in 2000, Joe makes an annual Roth IRA contribution of $2,000. As of 2008, he has contributed $16,000 and the account has earned $3,000 in interest. If Joe is over age 59 1/2 he can withdraw the entire $16,000 in contributions and $3,000 of interest tax free since it has been more than 5 years since he made his initial Roth IRA contribution.
Roth IRA contributions are disallowed when a joint filer has $169,000 in modified adjusted gross income (MAGI) and a single filer has $116,000 of MAGI.
The Strategy
Beginning in 2010, there will no longer be an income phaseout for Roth IRAs. In the meantime it can be beneficial to make traditional IRA contributions during 2008 and 2009, and then convert these contributions to a Roth IRA in 2010.
Example: Joe’s income is too high for him to make a Roth IRA contribution. He can wait until 2010 to make a Roth IRA contribution. If he doesn’t want to wait, he can make $5,000 traditional IRA contributions in 2008 and 2009, and then convert the $10,000 traditional IRA account (plus earnings) into a Roth IRA in 2010. Additionally, Joe can make a $5,000 Roth IRA contribution in 2010.
The point of this strategy is to get as much money as possible into a Roth IRA by 2010. I’ve gone over the basics of the strategy, but it is very important to talk to a tax professional before implementing the strategy to make sure it is done correctly.