As a followup to my post earlier this week on Roth IRA income limits, I wanted to highlight how we typically make our Roth IRA contributions. For background, we’re in a relatively high (and variable) income tax bracket. Because of this, we flirt with the Roth income limits on an annual basis, and it’s hard to know for certain whether we’ll be above or below the line until late in the year.

While we could wait until the end of the year, or even early the following year, to determine whether or not we can contribute, I’d rather get it knocked out right away. Thus, we make what others have termed “backdoor” Roth IRA contributions.

For background, the income limits for converting from a traditional IRA to a Roth IRA went away back in 2010. Beyond this, there are no income limits for contributing to a traditional IRA. Yes, there are income limits for determining whether or not you can deduct your traditional IRA contributions, but you’re free to contribute no matter how much you make.

The workaround, then, is to contribute to a traditional IRA (this will be non-deductible if you make enough to be ineligible for a Roth) and then convert it to to a Roth IRA. And that’s exactly what we do every January. For those of you that invest with Vanguard, I’ve outlined the steps below to show you exactly how it’s done…

For starters, you’ll need to make your traditional IRA contribution. There are a variety of ways to do this, with the easiest be funding your IRA from a linked bank account. For now, I’ll assume that you’ve already done this.

Once your traditional IRA fund are in place, simply log in and select “Exchange (Sell funds to buy funds)” option from the “Transact on this account” pulldown menu.

When asked what you want to sell, choose the traditional IRA holding(s) that you wish to convert out of. When asked what you want to buy, choose the Roth IRA holding(s) that you wish to convert into.

Once you click to review, you’ll be warned that “A conversion is a taxable event. Generally, you’ll owe taxes on the amount you convert from your traditional, SEP, or rollover IRA into a Roth IRA.”

Assuming that you made a non-deductible contribution, that you don’t have any untaxed gains in the account you’re converting, and that you don’t have any other non-Roth IRA IRA accounts in your name, however, there will be no tax liability*. It will be as if you had contributed directly to the Roth IRA in the first place, except you’ll have circumvented the income limits.

Given the above, I selected the “Do Not Withhold” option when asked about tax withholding and then submitted the order.

That’s it. We’ve now fully funded our Roth IRAs for 2012 and don’t have to think about whether or not we’ll finish above/below the income limits.

*Note: If you have previously made tax-deductible contributions to a non-Roth IRA, even if they’re in a different account, making a conversion like this will generate a tax liability. The reason for this is that the IRS views all of your IRAs as one big pot of money, and they don’t let you pick and choose which dollars you convert.

The good news is that money in “qualified” plans, such as 401(k) or 403(b) plans, is not included in the tax calculation, so you could conceivably move all of your pre-tax money into a Solo 401(k) to effectively hide it before doing the “contribute and convert” thing.

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