One of the most common questions we get from clients involves Roth IRA accounts. Everyone seems to have a general idea that Roth IRAs are good, but there's confusion on WHY and if Doctors are allowed to use them. We also get several questions from clients about Roth IRA conversions, commonly known as a backdoor Roth IRA for doctors. Here is all that you need to know about traditional and Roth IRAs, the backdoor Roth IRA, and actionable steps you can take to create one (with a professional, of course).
Let's start by discussing the difference between a traditional IRA and a Roth IRA.
When creating a sound investment strategy, you want to ensure it makes sense for your future. Whether you are investing for business purposes or retirement, your strategy should fit your overall financial plan.
Today, we are going to specifically look at investing for retirement. You may have heard of a traditional IRA and a Roth IRA. You may also have heard that many favor a Roth over a Traditional IRA. Why is this? To understand this, it's helpful to compare the Roth IRA and traditional IRA side-by-side. Below is a closer look at the facets of each.
A limited annual contribution is the maximum amount of funds you are allowed to contribute to your IRA account in a given year.
For 2024, the annual contribution limit for traditional and Roth IRAs is $7,000 (or $8,000 if you are 50 or older), but this number does change every year.
The IRS has set aside certain tax laws for traditional and Roth IRA accounts, and there are significant differences between them.
Contributions to a traditional IRA may be tax deductible, and no taxes are due while the money stays in the account. But when you take money out of a conventional IRA, all the growth will be subject to income tax—and possibly the principal, too—at whatever tax rate you happen to be in at the time.
With Roth IRAs, the contributions are never tax deductible. However, all of the withdrawals you take in retirement are income tax-free. This can be beneficial if you have a long time for the money to grow. We like to use the following farming analogy to describe the difference. With a traditional IRA, you get a tax deduction on the seed, but the harvest is all subject to tax. With the Roth IRA, the seed has no tax savings, but the entire harvest is tax-free.
There are sometimes specific income stipulations with the different types of IRAs. Here are the income limits for the traditional and Roth IRA:
Traditional IRAs do not have an income limit. You can contribute to one regardless of your income and earnings.
Roth IRAs do have an income limit. Most physicians are generally not eligible to contribute directly to Roth IRAs because they earn too much.
The IRS rules prohibit anyone earning over approximately $146,000 if you're single or $230,000 if you're married from contributing to a Roth IRA. However, those same income limits do not restrict high-income earners from converting their traditional IRA contribution to a Roth. This allows for a strategy called the "backdoor Roth IRA." These Roth IRA income limits are based on modified adjusted gross income and change yearly.
According to Investopedia, "A backdoor Roth IRA isn't an official retirement account. Instead, it is an informal name for an IRS-sanctioned way for high-income earners to fund a Roth IRA — even if their income is higher than the maximum the IRS allows."
How does this "IRS-sanctioned way" work? Next, we will go through how to create a backdoor Roth IRA strategy even if you earn more than the maximum income limit.
Here's how a Backdoor Roth IRA works:
Again, it does not matter how much you make. Everyone can save up to the annual contribution limit in an IRA each year. The odds are that because of your income and other rules, this will not be tax deductible for you, which is fine. Remember the above analogy - your seed will be taxed, but your harvest will be tax-free.
After the deposit has been made to your traditional IRA account, you will fill out a form to convert the balance to a Roth IRA. Converting is allowed for everyone, including high-income earners. Contributing directly to the Roth IRA is only allowed if your income is below certain limits.
After you have converted your non-deductible IRA contribution to a Roth IRA, you can now invest your money into your IRA however you want. Your money will have the opportunity to grow and can be withdrawn tax-free when you're retired.
There are some key details and caveats that affect what is best for you and your family, so be sure to consult with your CPA or tax preparer first. We hope you will now have a better idea of the difference between a traditional IRA and a Roth IRA and how even high-income physicians can start building tax-free money.
Editor’s Note: This article was originally published in April 2020 and has been updated for freshness and accuracy.
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Shane Tenny is the managing partner of Spaugh Dameron Tenny. Along with hosting the Prosperous Doc® podcast, Shane has a true passion for behavioral finance, helping clients and audiences understand how to develop successful strategies based on their unique temperaments. An accomplished and highly engaging speaker, Shane is regularly interviewed for television and podcasts, is actively involved in the Financial Planning Association®, and contributes to industry advisory boards.
