Tax free Income: Why Roth IRA strategy is important for physicians

An internist client of mine in Pittsburgh retired recently, looking forward to traveling somewhere warm, which is his passion. Although he’s a newer client, we’ve built the sort of relationship where I speak to him and his wife regularly about their new daily routine and how drastically life has changed during the pandemic. The theme that always comes up is how much they miss traveling. My client worked throughout his career to save money in tax by contributing pre-tax funds into his retirement account.

As he nears 70, he’s concerned about the RMDs (required minimum distribution) which will kick in soon. As a physician, he has accumulated a large portion of his net worth in pre-tax 401(k) and IRA accounts, and the reality of the hefty taxes that will be levied on his upcoming distributions is a major concern. The recently-passed SECURE Act in 2020 didn’t help either—it killed the stretch IRA by making it mandatory that an inherited IRA must be exhausted within 10 years after both spouses pass away. 

This is not an uncommon situation facing high earners such as physicians during retirement, as many in the medical field are in the highest tax bracket. In retirement, tax-free income is the ideal way to take distributions, and a Roth IRA remains one of the best ways to get that benefit.

However, high earners like physicians and dentists may feel locked out of some tax-free withdrawal options as their high income disqualifies them from opening Roth IRA accounts. They may be unaware of some tools that could be at their disposal to get those same benefits, such as the backdoor Roth IRA and Roth IRA conversions.

So, what is a Roth IRA?

A Roth IRA is an individual retirement account (IRA) where the investor pays taxes on the money funding the account upfront, unlike a Traditional IRA, where the money is taxed when it is withdrawn. While funds are in the account, the assets grow tax free, and future withdrawals are tax-free as well. They tend not to be vehicles for high earners; if an investor makes too much money, they cannot use a Roth IRA.

The limit for single individuals in 2021 is $140,000, and for married couples, the current limit is $208,000. Roth IRAs work well as a strategy when it seems that taxes will be higher in retirement than they are when funding the account. However, there are no age limits for contributions, and the account can be held indefinitely, without the required distributions that are a feature of Traditional IRAs.

Are there contributions limits in a Roth IRA?

Unlike those made to other types of accounts, contributions to a Roth IRA must be in cash, rather than in the form of assets. The annual limit amount is sometimes adjusted by the Internal Revenue Service; for 2020, the limit is $6000 for the year. There is an exception for those over the age of 50; those individuals can contribute up to $7000 annually. There is no tax deduction available for Roth IRA contributions.

What are the benefits of a Roth IRA?

There are several benefits of Roth IRA accounts. First off, money contributed to the account can be withdrawn at any time, whether for buying a house or living expenses. Investment returns taken as distributions may be taxed as income or changed an early distribution tax, so it makes sense to leave that money in the account longer. There is also no RMD requirement in Roth IRAs, as there is in a Traditional IRA, and no tax during any distributions after age 59 ½, again unlike Traditional IRA accounts, which makes them very attractive for tax-free growth and income.

If someone’s income is too high, are there any other ways of contributing to a Roth IRA?

There are several ways high earners like physicians can contribute to a ROTH IRA, including the 401(k) Roth IRA, a backdoor Roth IRA, and a Roth IRA conversion.

What is a Roth 401(k)?

By adding a Roth IRA option to a 401(k), the hybrid product offers unique benefits. This plan allows both employers and employees to continue post-tax earnings to their accounts. This little- to no-cost addition to a 401(k) means that the tax-free growth of those funds as well as the tax-free later withdrawal found in a classic Roth IRA account are now features of the plan. This option is often seen as a good strategy for owners or highly compensated employees who earn too much to open regular Roth IRA accounts. The Roth 401(k) lacks any income cap, so high earners can make use of it to gain those Roth IRA benefits that would otherwise be closed to them. The contribution limits in this type of account are age-based, with a current limit of $19,500, however, individuals over the age of 50 may contribute a catch up of an additional $6500. 

Also, upon retirement or leaving employment, an investor may convert the Roth 401(k) to a Roth IRA and thereby avoid the RMD that would be required from a Rollover IRA.

What is a backdoor Roth IRA?

As mentioned earlier, Roth IRAs are not usually available to high earners because of their level of income. However, there is a way to reap the benefits of the Roth IRA even if an individual is in that high income bracket. A backdoor Roth IRA is not actually a type of Roth IRA but a strategy, and one that is one of the most underused by physicians. This entails contributing money to a Traditional IRA then doing a Roth IRA conversion and paying those owed upfront taxes at that time. There is no income limit on a conversion of this type, so the funds are now properly established to gain the benefits of a Roth IRA. 

For a larger funding amount, a married investor can make contributions for 2020 and 2021 together and then do the Roth IRA conversion, meaning $14,000 for the investor and then $14,000 for their spouse.

What are the benefits of a backdoor Roth IRA?

There are many advantages to saving with a Roth IRA. By doing a Roth IRA conversion, there is no tax on the principal. The money in the account grows tax-free and future withdrawals are tax free, just as if the account had been a Roth IRA account all along. As Traditional IRAs have no income or conversion limits, if an individual already has money sitting in an existing IRA, that can all be converted as well.

Here’s an example of growth in a Roth IRA: If this year, a married couple each contributed $7,000 to Roth IRAs to start, and then an additional combined $14,000 annually for the next 20 years. Considering a 7% rate of return, at the end of the 20-year period, they will have over $668,000 from just those two Roth IRAs. When the couple takes withdrawals, all of the income from those distributions will be tax-free.

What are the disadvantages of a backdoor Roth IRA?

One issue to keep in mind to use the backdoor ROTH IRA, is the pro-rate rule if you have an existing IRA account open. In the case of converting an already existing Traditional IRA account, the IRS considers the combined balance of all of the investor’s Traditional IRA accounts when determining how much tax is owed on the converting funds. If, for example, the investor has 70% pre-tax money and 30% after-tax money, that is the ratio that will determine what percentage of converted money will be taxable. No matter how much is converted or from which IRA account, 70% of the converted amount will be taxable. This pro-rata rule is applied using the investor’s total IRA balance at year end rather than at the time of conversion.

What is the solution for the disadvantages of the pro-rata rule?

One option could be to move Traditional IRA funds to a 401(k) or other qualified employer plans, as 401(k) amounts do not count toward the balance used to determine the percentage of taxed money for the Roth IRA conversion. After this, a new Traditional IRA can be opened, then that can be converted to a Roth IRA as planned. These are complicated strategies, however, and it’s best to speak to a financial advisor who will look at your full tax situation before including solutions like these in a retirement plan.

What about a simple Roth IRA conversation?

There is no income restriction on Roth IRA conversion. If an individual already has money sitting in an existing IRA account, that can all be converted to a Roth IRA as well. However, taxes are a consideration when deciding if a Roth IRA conversion is a good fit for an investor. As the taxes will have to be paid up front when the Traditional IRA is converted, it makes sense to analyze what the tax bill will look like at that time. Particularly for older clients, it is important to see if the amount of taxes paid will outweigh the benefits of the potential Roth IRA. An ideal situation for a Roth IRA conversion is when the market is down with an expected recovery. 

For example, in 2020 during the start of the pandemic, the Dow Jones fell more than 30% in March but has rebounded sharply to where it is today. If an individual converted an IRA account to a Roth IRA at that time, there would have been lower taxes during the conversion and the funds would then continue to grow tax-free in the Roth IRA. An investor can also consider a partial Roth conversion to transfer those particular funds that may be down but are expected to recover.

Is a backdoor Roth IRA or ROTH conversion the best strategy for me?

This is not to suggest that a Roth IRA is the ultimate solution for every retirement plan. There are definite advantages to having pre-tax deductions upfront and contributing to Traditional IRA accounts or qualified tax deferred plans. As is evidenced by the analyses needed to determine if the conversion is advantageous to the investor and that the tax bill won’t make the whole conversion cost more that it’s saving, this can be a complicated strategy. But tax-free income from a Roth IRA can add advantages if implemented properly for high earners like physicians during retirement. 

Because some careful planning is required to get a backdoor Roth IRA set up or to get a Roth conversion moving and to make sure it’s the best fit for your situation, it’s a wise move to consult with an experienced financial advisor who will take the time to do a thorough analysis of your personal situation and work with you to find the best strategies to secure your financial future. 

Syed Nishat, BFA, is a partner at Wall Street Alliance Group. He holds a bachelor’s degree in business administration from University of Nevada Reno. Syed holds the FINRA Series 7, FINRA Series 63 and FINRA Series 66 licenses, along with licenses for life, disability and long-term care insurance. He also has been awarded the Behavioral Financial Advisor (BFA) designation.

Securities offered through Securities America, Inc., member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. Wall Street Alliance Group and Securities America are separate companies. Securities America and its representatives do not provide tax or legal advice; therefore, it is important to coordinate with your tax or legal advisor regarding your specific situation.