During medical school, residency, or fellowship, some physicians and dentists open a Roth IRA in order to get a jumpstart on investing. Even though contributions to a Roth IRA cannot be deducted from income tax, it is an attractive investment vehicle because withdrawals are tax-free as long as they are made after age 59-1/2.
The perceived issue with opening a Roth IRA - especially for physicians and dentists - is the income cap. If you are single and below age 50, you can contribute up to $5,500 per year to a Roth IRA. However, that contribution amount begins to phase out once your income reaches $118,000, and caps completely once your income reaches $133,000. If you're married, contributions begin to phase out at $186,000, and are capped at $196,000.
Since contributions can no longer be made once annual incomes exceed those amounts, many physicians and dentists must stop making contributions to their Roth IRA within the first year or two of full-time employment.
Traditional IRA's have no income caps (although you must make at least a minimum income to qualify). Therefore, retirement savings can begin as soon as you're ready - even in medical school - and contributions can increase along with your earned income once you begin full-time employment. With a Traditional IRA, contributions are deductible for those with incomes below $119,000, but become non-deductible once that income amount is surpassed. The growth of a Traditional IRA is tax-deferred (rather than tax-free like a Roth), regardless of whether the contributions were deductible or non-deductible, so taxes are paid on the growth of the money at the time of withdrawal.
BACKDOOR ROTH CONVERSION
That means, because of their income level, most physicians won't be able to make deductible contributions to a Traditional IRA, but they will also be unable to directly contribute to a Roth IRA. However, the two working together will allow for the Backdoor Roth Conversion to accomplish the equivalent of a normal Roth contribution.
In 2010, a policy that prevented converting Traditional IRA's into Roth IRA's for those who earned more than $100,000 expired, creating what became known as the Backdoor Roth Conversion. The process of conversion is when you make contributions to a Traditional IRA, then convert some or all of those funds to a separate Roth account. Once the funds are converted and moved to the Roth account, the growth of the account will be tax-free.
IS THERE A CATCH?
There's not exactly a "catch," but there are certain parameters that affect how these conversions are taxed. While it's true that anything converted to a Roth IRA will be withdrawn tax-free, taxes on the overall growth of the Traditional IRA will be applied at the time of conversion. Taxes will also apply to any deductible contributions made to the Traditional IRA when converting to a Roth IRA. Since most physicians and dentists exceed the income of $119,000, their Traditional IRA contributions are typically post-tax (non-deductible). In this case you would only pay taxes on the growth of the Traditional IRA at the time of the conversion to a Roth. For many, growth is negligible or nothing as they typically process the conversion immediately following or shortly after the contributions to their Traditional IRA. I always suggest holding the funds in the Traditional IRA for a year to avoid violation of the “Step Transaction” rules potentially enforced by the IRS.
In some cases, Traditional IRA's have a combination of pre-tax and after-tax contributions. In this case, a calculation will be made based on the percentage of after-tax funds in the IRA to determine what will or will not be considered taxable income at the time of conversion.
CAN I IMMEDIATELY CONVERT TO A ROTH IRA?
This is an important question. Some would suggest making the maximum contribution to a Traditional IRA, and then immediately converting to a Roth IRA so you can take advantage of market returns that are tax-free. Technically, this is legal. But what others might suggest is that something called the step transaction doctrine might come into play.
A step transaction doctrine is the legal principle that a series of related steps in a transaction should be taxed based on the overall economic nature of the transaction, not based on the individual steps.
That means the IRS might see a Backdoor Roth Conversion as more than just a single transaction, and tax it according to its broader purpose. This logic would suggest that rushing a conversion might draw unnecessary IRS attention and, if taken to court, the step transaction doctrine could be invoked, levying taxes and penalties against the investor.
To avoid the step transaction rules, an investor might place the money in a Traditional IRA and hold it for a year. The funds would not be invested in order to avoid paying taxes on the growth at conversion, especially given a physician's income level. But, once the conversion takes place and the funds are transferred to a Roth, the money can be invested for the first time. From that point forward, any investment growth would be tax-free.
DOES IT MATTER IF I HAVE MULTIPLE IRAs?
It does. This is known as the IRA Aggregate Rule. The IRA aggregate rule stipulates that when an individual has multiple IRAs, they will all be treated as one account when determining the tax consequences of any distributions (including a distribution out of the account for a Roth conversion)." This means that a conversion to a Roth IRA could trigger a taxable event on all IRA accounts, even if only converting from one.
SHOULD I USE A BACKDOOR ROTH CONVERSION?
It all depends on your financial situation and strategy. While there are many options to weigh and rules to consider, a Backdoor Roth Conversion does make sense for many physicians and dentists. The decision should be made in the context of reviewing your entire financial plan. If you anticipate you’ll have a higher effective tax rate in the future when you intend to withdraw the money, a Roth IRA will make sense. If you anticipate you’ll have a lower effective tax rate at the time of withdrawal than when making contributions, I would suggest contributing to any eligible pre-tax accounts first. Most physicians and dentists will have enough cash flow to max out any available pre-tax account options and a Roth IRA; therefore, this question isn’t really relevant for this audience. The only other account options would require post-tax contributions with tax-deferred growth, which would be taxed as ordinary income or post-tax contributions with growth taxed at long-term capital gains rates. Neither of which provide tax-free growth.