The Back-door Roth IRA ( from Natalie Choate, ataxplan.com)

How to get around the Income Limit for Roth IRAs

Question: If a high-income taxpayer makes a nondeductible IRA contribution, is he free to convert it to a Roth IRA immediately? Or would this be deemed an excess Roth conversion if done in the same year?

Natalie: He is free to convert it immediately. It would not be deemed an excess Roth IRA contribution. There's no legally required waiting period; however, it would make sense to wait until you have received adequate documentation that the original contribution was made to a traditional IRA, just so the record is absolutely clear.

For some reason, Congress left income limits in place for making "regular" (annual-type) contributions to a Roth IRA, even though they removed the income limit for conversion contributions. So this sequence (contribute to a traditional IRA, then immediately convert the account to a Roth) will be very popular with everyone who (1) wants to make a regular contribution to a Roth IRA but is ineligible to do so and (2) is eligible to contribute to a traditional IRA. To be eligible to make a regular contribution to a traditional IRA you must have compensation income at least equal to the contributed amount and be younger than age 70½ as of the end of the contribution year.

As a reminder, the fact that the participant is converting a newly-created IRA (funded with a nondeductible contribution) does not mean that the conversion is automatically "tax-free." The conversion of a newly-created traditional IRA is taxed just like the conversion of any other traditional IRA; you do not look only at the pre- and after-tax money in the particular account he happens to be converting.

The nontaxable portion of any IRA conversion (whether of a brand new account or an IRA you've held for years) is determined the same way. You multiply the converted amount by a fraction. The numerator of the fraction is the total amount of after-tax money the participant has in all of his traditional IRAs. The denominator is the total combined value of all of the participant's IRAs. The amount that results from applying this fraction is the only amount that you can treat as the tax-free conversion of after-tax funds-regardless of which account the conversion actually came from.

Example: Fred and Ed each make nondeductible $5,000 contributions to their respective newly created traditional IRAs on Monday, March 1, 2010. A week later, each of them converts his newly created $5,000 traditional IRA to a Roth IRA. Even though they both followed exactly the same steps, they have very different tax results.

For Fred, the newly created $5,000 traditional IRA is the ONLY traditional IRA that he owns. Fred's conversion is "tax free" because he's converting 100 percent after-tax money.

Ed, on the other hand, in addition to his newly created $5,000 traditional IRA, also owns a $95,000 rollover traditional IRA. The rollover IRA is 100 percent pretax money. To determine how much of Ed's 2010 conversion is tax-free, we multiply the $5,000 conversion amount by the following fraction:

$5,000 (that's the total of Ed's after-tax money in both of his traditional IRAs)
$100,000 ($95,000 + $5,000; the total combined value of all Ed's traditional IRAs)

$5,000/$100,000 times $5,000 = 5%, meaning that only $250 of the $5,000 conversion is deemed to come from the after-tax money in Ed's IRAs. The other $4,750 of his conversion is included in his gross income.

I have simplified the fraction for purposes of illustration; it's actually based on year-end values.

So yes the strategy is legal and safe and it works--but don't fall into the trap of thinking the conversion is automatically tax-free just because you are converting a new account funded only with nondeducted contributions.
Resources: See Chapter 2 of the author's book Life and Death Planning for Retirement Benefits for how to compute the taxable and tax-free portion of any distribution; $89.95 plus shipping at www.ataxplan.com or 800-247-6553. For complete explanation of all aspects of Roth IRAs and other Roth retirement plans, get Natalie's 97-page Special Report Roth-Ready for 2010!, downloadable for $49.95 at www.ataxplan.com.