While death and taxes affect us all, the only really sure thing in life is that people will do whatever they can for a tax break. With all the money that's at stake, it's no surprise that people and businesses go to such great lengths to reduce or avoid their taxes.
Still, the actual methods that taxpayers use boggle the mind. For example, financial guru Wade Cook was recently sentenced to more than seven years in prison for trying to get out of paying taxes on book and seminar sales, using trusts and limited partnerships to hide income. Multinational corporations like General Electric (NYSE: GE ) and Xerox (NYSE: XRX ) with significant foreign subsidiaries often legitimately use profits for foreign investment rather than incurring tax by bringing those profits back to the U.S. -- even when the applicable tax rates were reduced substantially.
Sometimes, however, techniques that promise to reduce taxes don't work the way people think they will. One strategy that involves IRA contributions and conversions, for example, may not prove to be the tax saver that some believe it will.
The Roth back door
The Roth IRA is the largest tax break for individuals ever created. Once you contribute to a Roth IRA, you'll never pay a dime of taxes as long as you follow its distribution rules. If you pass away before using all the money, your heirs won't have to pay income tax either. It's a great deal.
There's a catch, though: High-income taxpayers can't take advantage of that great deal. For 2007, if you earn more than $114,000 as a single taxpayer or $166,000 as a married couple, you can't make a Roth contribution. But planners are pointing to new provisions set to take effect in 2010 that could give everyone a chance at a Roth.
In 2010, the current income limits on converting a traditional IRA to a Roth IRA are slated to disappear. Therefore, you can contribute to a traditional IRA now, and then convert to a Roth in 2010. Most high-income taxpayers covered by employer retirement plans can only qualify for a nondeductible IRA. But even if you won't get a deduction now, many planners are suggesting that you'll only have to pay tax on the earnings when you convert.
Not that simple
Unfortunately, it's a little more complicated than that. The planners are right if the nondeductible IRA you use for this strategy is the only IRA you own. But if you have other IRAs -- including ones you opened by rolling over money from an employer plan -- you could take an unexpected tax hit.
Here's the problem: Converting an IRA is 100% taxable if you took deductions for your contributions. Moreover, if you have two IRAs, one of each type, you can't just choose to convert the nondeductible one. Instead, the IRS treats you as having converted a prorated portion of each. So if your two IRA accounts have the same balance, about half of your original contributions will be taxed. That could create a huge tax bill -- one that could also lead to interest and penalties if you haven't planned for it adequately.
Nevertheless, you may be able to work around the problem. If your other IRA is a rollover from a previous employer, you may be able to roll it into a 401(k) or other retirement plan with your current employer. The rules don't apply to 401(k) money, so getting rid of your other IRA would leave you with just the nondeductible IRA.
Be careful out there
When you hear about potential tax breaks, you should always be a bit wary. Given how complicated the tax code is, many provisions may not apply to you, or there may be other factors that will keep you from using a tax break or reduce your savings from using it. And while a big company like Black & Decker (NYSE: BDK ) has the resources to fight the IRS successfully, you might not want the hassle.
But that doesn't mean you shouldn't take full advantage of any tax provisions that do apply to you. If it's the only IRA you'll have, using the nondeductible IRA strategy as a back door to a Roth could end up saving you plenty.
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Fool contributor Dan Caplinger does everything he can -- legally -- to lower his taxes. He doesn't own shares of the companies discussed in this article. The Fool's disclosure policy is never too good to be true.
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