Learn more about ROTH IRAs with Shane Tenny, CFP®.
SHANE TENNY: 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 definitely some confusion on why and if physicians are even allowed to use them.
So let's start with the first question. What's good about Roth IRAs and to understand this, it's helpful to actually compare them to a traditional IRA. You see, both accounts are limited to an annual contribution of $5500, but that's about where the similarity ends. You see, money that's contributed to a traditional IRA may be tax deductible when it's put in and there's not taxes due while the money is in the account.
But when you take money out of a traditional IRA, all of the growth will be subject to tax and possibly the principal too, to whatever tax rate you happen to be in at the time. With Roth IRAs, however, the contributions are never tax deductible. However, all 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.
Sometimes I use a little farming analogy to describe this. With a traditional IRA, a deductible IRA, you get a deduction on the seed, but you'll pay tax on the harvest. Whereas with a Roth IRA, the seed is after tax and there's no savings on it. But the entire harvest is tax-free. So the next issue that most physicians have, once they're in practice, is that they're not eligible to contribute directly to a Roth IRA because they earn too much money.
The IRS rules prohibit anyone earning over $117,000 if you're single or about $184,000 if you're married from contributing to a Roth. But those same income limit rules do not apply to IRA contributions, which opens up a neat little strategy that sometimes it's called a backdoor Roth.
Here's how the backdoor Roth works. First, you contribute money to a regular IRA. Again, it doesn't matter how much you earn because everyone's allowed to save $5500 there and odds are because of your income and other rules, this won't be a deductible contribution for you, which is fine. After the deposit is made, you fill out a form to convert the balance to a Roth IRA.
Yes, the devil is in the details here. Converting is allowed for everyone. Contributing is only allowed if your income is below certain limits. So once you convert your nondeductible IRA to a Roth, you can now invest however you want. Hopefully grow a whole bunch of money that can all be withdrawn tax-free when you're retired.
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. But hopefully now you have a little better idea of the difference between IRAs and Roth and how even high-income physicians can start building tax-free money. Hope this helps. We'll talk to you soon.
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.