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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.
Watch our video here on the Roth IRA, or keep reading below:
When creating a sound investment strategy, you want to make sure that it makes sense for your future. Whether you are investing for business purposes or retirement, you want to make sure that you have a strategy that fits your overall financial plan.
Today, we are going to specifically look at investing for retirement. You may have heard of a traditional IRA and Roth IRA. You may have also heard that many favor the Roth over a Traditional IRA. Why? To understand this, it’s helpful to compare both the Roth IRA with traditional IRA side-by-side. Let's dive into some of 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. Does a traditional IRA or Roth IRA have a cap?
Both a traditional IRA and Roth IRA are limited to an annual contribution of $6,000 (or $7000 if you’re age 50 or older). This means that you can put no more than $6000 (or $7000) in a given year.
The IRS has set aside certain tax laws for both the traditional and Roth IRA accounts. Let's look at some of the differences between the two.
Money that is contributed to a traditional IRA may be tax deductible, and there’s no taxes due while the money stays in the account. But, when you take money out of a traditional 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! So if you have a long time for the money to grow, this can be really beneficial. We like to use this 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, there’s no tax savings on the seed but the entire harvest is tax-free.
There are sometimes certain income stipulations with the different types of IRAs. Here are the income limits for the traditional and Roth IRA.
Traditional IRA
Traditional IRAs do not have an income limit. You can contribute to a traditional IRA no matter how much you earn.
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 $117k if you’re single or $184,000 if you’re married from contributing to a Roth. But, those same income limits do not restrict high-income earners from converting their traditional IRA contribution to a Roth IRA. This opens up a neat strategy called the “backdoor Roth IRA”.
According to Investopedia, "A backdoor Roth IRA isn't an official retirement account. Instead, it is an informal name for a 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? Let's discuss how to create a backdoor Roth IRA strategy even if you make over the maximum income amount.
Here’s how a back door Roth works.
Again, it doesn’t matter how much you make. Everyone’s allowed to save $6,000 to an IRA each year. And odds are, because of your income and other rules, this won’t be tax deductible to you – which is fine.
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. Contributing is only allowed if your income is below certain limits.
So, once you convert your non-deductible IRA contribution to a Roth, you can now invest however you want and your money has the opportunity to grow and can be withdrawn tax free when you’re retired.
Now obviously there are some key details and caveats that go into this whole topic, so make sure to consult with your CPA or tax preparer first. We hope that you will now have a better idea of the difference between the IRA and Roth and how even high-income physicians can start building tax-free money.
Want to see if you are on track for retirement? Download the Free Retirement Checklist to make sure that are prepared for life after medicine!
This blog was originally published on April 15, 2019 and has been updated on November 9, 2020 for accuracy. | CRN202104-246165
CFP® and Partner at Spaugh Dameron Tenny, LLC
