Ins and outs of "backdoor" Roth IRA contributions for physicians

Roth IRA's are powerful tax fighting vehicles most physicians can use to save for retirement, yet many doctors haven't the foggiest notion about Roth IRA's and next to none of them understand the "backdoor Roth IRA contribution" that makes a Roth IRA possible. Now you can be the first kid on your block to "get" the Roth IRA thing. Keep reading...

 What is a Roth IRA? and why should physicians care?

The Roth IRA is one of the most powerful tax deferral vehicles a physician family has at its disposal. Two features make them great:

  1. Roth IRA's grow tax-free… forever. Unlike Traditional IRA's, you can leave the money in your Roth IRA until the day you die. There are no required minimum distributions that would otherwise begin at age 70 1/2.
  2. Qualified Roth IRA distributions are tax-free. For most physicians, that means you can spend the money after you've reached age 59 1/2 and pay zero income taxes.

Every nickel you cram into a Roth IRA has the potential to grow like a weed and never, ever be taxed. Traditional 401ks, municipal bonds and variable annuities cannot lay that claim.

 So why doesn't every physician have a Roth IRA?

It's simple: the average doctor is not allowed to make a direct contribution to a Roth IRA, so they don't contribute. The IRS says that physician families (married, filing jointly) who earn more than $188,000 (in 2013) are NOT ELIGIBLE to make a diret contribution to a Roth IRA. Period.

Don't worry. You can still get money into a Roth IRA using a "backdoor" contribution. Even though this tax planning strategy has been covered by The Wall Street Journal, explained in excruciating detail by The Journal of Accountancy and recommended by The White Coat Investor, many financial advisors and tax preparers still overlook it. If it's news to you, you're not alone.

 Which doctors should install a backdoor to their Roth IRA's?

You're a good fit for a backdoor Roth IRA contribution if:

  • you don't qualify to make a direct Roth IRA contribution (as above),
  • you are covered by a retirement plan at work, and
  • you have already maxed out your tax-deductible contributions to that plan.

 What exactly is a "Backdoor Roth IRA"?

Truth be told, there is no such thing as a "Backdoor Roth IRA". What I'm saying here is that there are still only two kinds of IRA's: Traditional, and Roth. Your Backdoor Roth IRA is nothing more than a regular old Traditional IRA that you yourself earmark as a "backdoor" to get money into your Roth IRA.

 How does the backdoor Roth IRA contribution work?

In the simplest case, it goes like this:

  1. Dr. Young and her husband have never saved a dime for retirement, so she has a zero balance in her retirement accounts at the beginning of this example.
  2. She starts work at a clinic making $300,000 per year, where she also maxes out her 401k or 403b plan.
  3. She opens both a Traditional IRA and a Roth IRA.
  4. She contributes $5500 to the Traditional IRA and, because she is covered by a retirement plan at work, she cannot deduct this contribution from her taxes and receives no immediate tax benefit.
  5. She then completes a one-page form known as a Roth Conversion Form and submits it to her brokerage.
  6. The brokerage removes or "distributes" the money from her Traditional IRA and plops it into her Roth IRA, thus completing the conversion.
  7. Voila! Dr. Young has pushed cash through her Traditional IRA into her Roth IRA via a Roth conversion, thus making an indirect contribution through the "backdoor".
  8. Early next year, her brokerage sends her a Form 5498 showing that she made the Traditional IRA contribution and a Form 1099-R showing that she made a distribution from that Traditional IRA.
  9. In April of next year, Dr. Young diligently reminds her tax preparer that she made a backdoor Roth IRA contribution so that she will not owe tax on the $5500 that was distributed from her Traditional IRA.
  10. She does the whole thing over again next year.

 Is the backdoor Roth IRA really that simple for the average physician?

In a word, the answer is "no". Most physicians already have a Traditional IRA and there is money in that account from either fully deductible contributions, rollover contributions, or both. This matter is more complicated when a self-employed physician owns a SEP-IRA or SIMPLE-IRA, both of which are counted as IRA's for the sake of Roth conversions.

When you do a Roth conversion, you cannot pick and choose which part of the IRA to convert, so physicians in this situation need to exercise great care (or get help from a great financial advisor) to avoid triggering a huge tax bill.

Here's an example of how NOT to do the backdoor Roth IRA contribution:

  1. Dr. Old has a Traditional IRA that holds $44,500 that was rolled over from an old 401k and he also has a $50,000 SEP-IRA that he started last year.
  2. He contributes $5,500 to his Traditional IRA account, bringing the balance up to $50,000.
  3. He then converts $5,500 worth of the Traditional IRA to a Roth IRA, thinking he won't owe any taxes on his backdoor contribution.
  4. When April 15 rolls around, Dr. Old is shocked to learn that 94.5% of the $5500 he converted is going to be taxed as ordinary income, since only 5.5% of the conversion is treated as "basis" from his recent non-deductible contribution. (The basis is $5,500, but it's only 5.5% of the overall IRA balance which now stands at $100,000 because the SEP-IRA and all of the rollover amount in the Traditional IRA is included in the calculation).

Roth IRA conversions obey what tax guru Ed Slott refers to as the "cream in the coffee" rule. When you take a "sip" from your Traditional IRA by converting some of it to a Roth IRA, you cannot choose to drink only the cream (the non-deductible portion). You must also drink a lot of the coffee itself (the tax-deductible portion), so be careful as you set up your backdoor Roth IRA contributions if you have a bunch of money in your IRA's already.

How to fix your broken backdoor

Some physicians will be able to avoid the "cream in the coffee" prorata taxation thing I mentioned above by rolling their old Traditional IRA into their 401k or 403b plan at work if their employer's plan allows it. This requires a lot of paperwork and planning but I believe the end result, a fat Roth IRA, is well worth the effort.

And before I go, let me leave you with one more tip. Your Roth 401k is NOT the same as your Roth IRA. Making contributions to aRoth 401k at work is probably a really bad move for the average physician. Most physicians will be better off making contributions to the Traditional sub-account of their 401k/403b since this allows you to defer taxes into retirement when you may be in a lower tax bracket.

Every physician family's backdoor Roth IRA contribution strategy is different and each one seems to have its own cute little twist, so make sure you really know what you're doing before you dive in, or ask your tax guru and your financial advisor to team up to make this easy for you.

Many thanks to Janet Davis, a Certified Public Accountant who works with physician families, for fact checking my post.