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Roth IRA Strategy for Physicians

Peter Thiel is among the wealthiest Americans and is worth $4.3 Billion.  In 1999, he worked for a software company where most of his compensation was from a stock grant.  Peter bought a stake in PayPal with 1.7 million shares valued at $.001 per share or $1,700.  He purchased the shares in his Roth IRA.  Today, his Roth IRA is worth over $5 Billion.  Wait, wait… how could a billionaire contribute to a Roth IRA?  Simple!  Peter earned $73,000 a year, which was less than the cutoff limit of $110,000 at the time for a single tax filer.  Physicians earn more in salary than the Roth IRA limits today.  How can they invest in a Roth IRA like Peter?  There is a Roth IRA strategy for physicians, and we will walk through it.

What is a Roth IRA

A Roth IRA, named after Delaware Senator William Roth, became a retirement savings option in 1998.  Senator Roth felt that after-taxed money could be contributed to an IRA-type account and grow tax-free until needed for retirement at 59 1/2 years old.  It allows a worker to invest up to a specific limit like a traditional IRA; however, when the earnings and contributions get withdrawn in retirement, there is no taxation.  In essence, it is a tax-free investment account.

Roth IRA Benefits

A Roth IRA allows your money to grow tax-free and can be withdrawn tax-free after 59 1/2.  Also, contributions made to a Roth IRA can be withdrawn tax-free.  Will those contributions be taxed when withdrawn?  No!  Since you already paid taxes on them, they are not taxed again.  However, any earnings on the money, if withdrawn, will be subject to taxation.

When the owner of a Roth IRA dies, and the account passes to their heirs, the heirs can take the money out tax-free.  The heirs must withdraw 100% of the funds by the 10th year after the year the owner dies. There are no required minimum distributions (mandatory withdrawals).  The heirs have gained 11 years of growth on the account by waiting to withdraw the money.

If your spouse does not work, but the family files a joint tax return, you can open a spousal Roth IRA.  If you earn $12-14,000 in income, you can contribute the maximum to your Roth IRA and your spouse’s Roth IRA.

Roth IRA Contribution Rules

Workers can only contribute to a Roth IRA if they have earned income.  Earned income is wages from a job or a business, which pays them a salary.  People who receive Social Security, rental, investment, or pension income do not qualify.

In 2022, the annual contribution limit for a Roth IRA is $6,000.   If you are over 50, you can add another $1,000 catch-up provision.  Thus, if you are over 50, you can contribute $7,000 a year to a Roth IRA.  However, you need to have earned at least $6-7,000 a year to contribute the maximum.

There is an income threshold a worker must review before contributing to a Roth IRA to make sure they are not over the limit.

Reviewing the income limits below, you notice that most physicians earn more than the limits allow.  Nevertheless, there is a Roth IRA strategy for physicians.

The Strategy: Backdoor Roth Conversion (Contribution)

Backdoor Roth Conversion is a strategy to allow high-income earners who exceed the IRS limits a way to contribute to a Roth IRA.  The backdoor Roth Conversion is not a tax dodge.  It is 100% legal.  You take the after-tax money that you would contribute into a Roth IRA and instead contribute the funds to your Traditional IRA.  Since the funds are after tax, you then roll over/convert the funds to your Roth IRA.  Thus, you have successfully contributed to a Roth IRA.  However, there are some items you need to be aware of before performing this strategy.

  1. Make sure you and your spouse do not have other funds in a Traditional IRA, Rollover IRA, Inherited IRA, SEP, or SIMPLE IRA.  If you do, you will not be able to convert the contribution amount as the IRS looks at 100% of the money contributed to these accounts as PRE-TAX.  Mixing after-tax and pre-tax money will be subject to the Pro-Rate Rule.
  2. The Pro-Rata Rule states that if after-tax money gets contributed to a pre-tax account, the percentage of the conversion taxed will be the pre-tax amount divided by the total amount.  Here is an example:

Suppose Joe has a balance in his Traditional IRA of $44,000 and then contributes $6,000 after-tax money to it.  Then, he wants to perform a backdoor Roth conversion of $6,000 to his Roth IRA; the percentage taxed is ($6,000 x ($44,000/$50,000)).  The amount of the contribution taxed is high because once the after-tax money gets contributed to the Pre-tax account, it gets mixed together with the pre-tax and cannot be unmixed.

Tips to Get Around Pro-Rata Rule

A beneficial way to get around the Pro Rata Rule is to transfer your Pre-Tax IRAs to your employer retirement program, such as a 401(k) or 403(b).  Doing so will empty your IRAs, thus allowing you to contribute 100% after-tax money to your Traditional IRA and then convert it to your Roth IRA.

Steps to Complete a Backdoor Roth Conversion

  1. Empty all non-Roth IRA accounts by transferring them to your employer’s retirement account.
  2. Contribute to your Traditional IRA to the limit of $6,000 or $7,000 (over 50).
  3. Leave the money in cash or the money market fund, so it does not make earnings.  Earnings would be taxable.
  4. Roll over or convert the contribution to your Roth IRA.
  5. Since there were no earnings on the after-tax money, the conversion is tax-free.
  6. Please speak with your CPA and tell them you performed a backdoor Roth conversion.  They should file Form 8606 for you.  If you perform your taxes, make sure you file this form.  YouTube videos show how to fill out the form.

To Conclude

Even though you are a high earner, it does not mean you cannot contribute to a Roth IRA.  A Roth IRA is essentially a tax-free investment account.  Your goal should be to contribute the maximum to this account each year.  It will grow tax-free and will be withdrawn tax-free in retirement.  Remember to follow the steps above and check your account after doing so.  The Backdoor Roth Conversion is the best Roth IRA strategy for physicians.


About The Author

Jordan Benold, CFP® provides fee-only financial planning and investment management services in Frisco, TX.  Benold Financial Planning serves clients as fiduciaries and never earns a commission or sells a product.

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