A Physician’s Guide to The “Backdoor Roth”

Many physicians aren’t eligible to make direct contributions to a Roth IRA, seemingly cutting them off from this popular and beneficial retirement savings vehicle. However, more and more high earners are using a retirement saving strategy that allows them to fund a Roth IRA account indirectly from other savings accounts. This strategy is called the Backdoor Roth.

Why Roth IRA?

Before examining the Backdoor Roth strategy, it’s important to understand what makes a Roth IRA worth pursuing in the first place. For those unfamiliar, a Roth individual retirement account (IRA) is a retirement savings vehicle that saves and grows after-tax contributions. 

Roth IRAs are considered tax-advantaged because, once retirees reach an eligible age, they can make withdrawals from their Roth IRA without having to pay taxes (because they already paid income taxes on the money before it was deposited to the Roth IRA account). Compare this to a traditional IRA, where contributions can be a mix of tax-deferred and after-tax, the money grows tax-deferred, and withdrawals are taxed as current income after age 59½.  

For many savers, “paying no taxes later” is preferable and can be advantageous from a planning perspective. When savers have already paid taxes, it’s easier for them to set retirement goals and forecast spending. 

Roth IRAs also make estate planning easier. Because savers have already paid taxes on Roth IRA savings, the money can usually be distributed directly to beneficiaries without any red tape from probate proceedings. 

There is an annual cap of $6,500 for Roth IRA contributions in 2023, but the IRS updates this limit every year. If you are an older saver (50 and up), you can make higher “catch-up” contributions up to $7,500 in 2023. 

Why many physicians aren’t eligible

The IRS enforces income limits on direct Roth IRA contributions, which means that many doctors (along with other high-earners) cannot make contributions to these accounts from a simple checking or cash account.

The 2023 income limit for Roth IRA contributions are: 

• $153,000 for single tax filers 

  
  

• $228,000 for those married and filing jointly

That means, if you or your household makes this amount of annual income or more, you cannot make direct contributions to a Roth IRA. Again, the IRS updates these limits every year, but this ceiling prevents many doctors from being eligible.

Additionally, deduction claims on traditional IRA contributions can be limited if a physician and/or their spouse have a retirement plan at work.

The good news: Anyone can own a Roth IRA, and many high earners have opened them and indirectly funded them using the Backdoor Roth strategy.

Navigating tax laws can be daunting. Earned has decades of combined experience providing physicians with comprehensive, 360-degree wealth management, including tax planning and investing for retirement. Get in touch with our team today to learn more.

How Backdoor Roth works

Essentially, the Backdoor Roth strategy involves converting money from a traditional IRA and putting it into a Roth IRA. This is how higher earners indirectly fund a Roth IRA and enjoy the advantages of an after-tax retirement account. You use IRS Form 8606 to report these conversions with your annual tax filing.

To keep this strategy tax efficient, savers need to be aware of the Pro-Rata Rule. This rule taxes these conversions based on pre-tax savings in your traditional IRA, SIMPLE IRA, or SEP IRA accounts. To illustrate how this works, let’s look at a simple example.

• In May, Dr. Jones deposits $5,000 (after-tax) in their traditional IRA that previously had no balance.

  
  

• In July, Dr. Jones converts that $5,000 to a Roth IRA. 

  
  

• On December 31st, Dr. Jones’ traditional IRA has a balance of $0 pre-tax dollars, the June conversion stays tax-free.

In this example, the Pro-Rata Rule wasn’t triggered because there was no remaining balance of pre-tax money in Dr. Jones’ traditional IRA account. Here’s how it would look if there was a balance that included pre-tax money: 

• In May, Dr. Jones deposits $5,000 (after-tax) in their traditional IRA that previously had no balance.

  
  

• In July, Dr. Jones rolls $10,000 from an old 401(k) into the same traditional IRA.

  
  

• In November, Dr. Jones converts $5,000 of the $15,000 in the traditional IRA to a Roth IRA. 

  
  

• On December 31st, Dr. Jones still has $10,000 in their traditional IRA and part of the October conversion will be taxed as income.

Essentially, you do not get to choose which pre or after-tax dollars get converted to your Roth IRA. So, the Pro-Rata Rule taxes these Backdoor Roth conversions based on the percentage of pre-tax money you had in all traditional IRA, SIMPLE IRA, or SEP IRA accounts.

In the example above, the IRS sees that Dr. Jones had $15,000 in their traditional IRA at the time of the conversion — two-thirds of which were pre-tax. Thus, the IRS will tax two-thirds of the $5,000 November conversion as income.

In Summary

Does the Backdoor Roth strategy require some extra financial vigilance and paperwork? Absolutely. And, without proper navigation, physicians can be blindsided with a bigger-than-anticipated tax bill when it comes time to file. 

All that said, the advantages of maintaining and growing a Roth IRA as part of a retirement plan are significant, as discussed above. It's recommended  that you speak to a financial advisor before attempting any Backdoor Roth conversions, as a professional can help you understand how your marital status, tax filings, and existing savings accounts can impact how to approach this tax-efficient strategy. 

At Earned our experienced financial advisors are well-versed in the specific challenges physicians face when managing their finances. If you’re a physician interested in funding a Roth IRA but are ineligible to make direct contributions, our team can help.

Contact our team at Earned to get started.