[Editor’s Note: One of my recent ACEP NOW columns concerns the Backdoor Roth IRA. It takes a while to wrap your head around this one, so I don’t mind addressing the subject multiple times. I’m still getting emails, forum posts, and blog comments every week with good questions about the Backdoor Roth. If you’re an attending physician, and not already funding one of these for yourself and your spouse, you’re probably making a mistake.]
QUESTION. My partner recently told me that I should be doing a “backdoor Roth IRA.” I nodded my head, but truthfully, I had no idea what he was talking about. What is a backdoor Roth IRA, and should I really be using one?
ANSWER. There are two main types of retirement accounts. The first is a pre-tax, or tax-deferred, retirement account such as a 401(k) or a traditional individual retirement arrangement (IRA). Money contributed to these accounts is deducted from your income for that year, reducing your tax burden for the current year. If your marginal tax rate (tax bracket) is 33 percent, then every dollar contributed to a tax-deferred retirement account saves you 33 cents on your tax bill. The money in that account then continues to grow without taxation until you pull out the money. If you are like most physicians, some or all of that money will be pulled out of the account during your retirement at lower effective tax rates. Tax-deferred retirement accounts are a great way to fund retirement income needs.
The second type of retirement account is a tax-free, or Roth, account. These accounts, named after Sen. William V. Roth Jr. of Delaware, also allow tax savings but in a different manner than a tax-deferred account. You contribute after-tax dollars to a tax-free account such as a Roth IRA or a Roth 401(k). The money then grows without taxation and, in retirement, is withdrawn from the account and spent tax-free. While the bulk of an attending physician’s retirement savings during peak earning years should probably be in tax-deferred accounts, it will be extremely handy to arrive at retirement with significant amounts of both tax-deferred and tax-free assets. Aside from contributing to tax-free accounts, it is also possible to convert tax-deferred accounts to tax-free accounts by paying the taxes due in the year of the conversion.
Prior to 2010, there was an income limit both on making contributions to Roth IRAs and on converting traditional IRAs to Roth IRAs. If you made a typical emergency physician income, you could neither contribute to a Roth IRA nor convert one of your traditional IRAs. However, starting in 2010, that income limit was removed from the conversion process, although not the contribution process. Under current law, a typical emergency physician cannot contribute to a Roth IRA but can contribute to a traditional IRA and then convert it to a Roth IRA.
The Pro-Rata Rule
The trickiest part about doing a backdoor Roth IRA is dealing with the pro-rata rule. A typical emergency physician can neither contribute to a Roth IRA nor deduct a traditional IRA contribution, although a traditional IRA contribution is permissible. This is known as a nondeductible traditional IRA. However, when doing a Roth conversion, the IRS does not permit you to just convert the nondeductible dollars into a Roth IRA. The traditional IRA must be converted pro-rata.
Check your return to ensure you did not do this. Line 15 and line 18 should be $0, not $5,500.
Perhaps the best way to understand this is to consider any existing tax-deferred IRA as a cup of coffee and the newly created nondeductible traditional IRA as cream. Once you put in the cream, there is no way to then pull out just the cream. It must be pulled out proportionally with the coffee. If you wish to convert just the cream, you’d better get the coffee out of the cup first. There are two ways to do that. The first is to simply convert the entire IRA to a Roth IRA. Anyone can do this, and it is quick and easy. However, if you have a large IRA (and in this term I include all of your traditional IRAs, SEP-IRAs, and SIMPLE IRAs), this can be very expensive because you would be paying taxes on all of the previously tax-deferred money at your current marginal tax rate. If you have a large IRA, you are likely better off transferring that money into an old 401(k), your current 401(k), or, if you are self-employed, an individual 401(k). That’s because 401(k) assets are not included in the pro-rata calculation.
This essentially empties the coffee out of the cup before you put in the cream, allowing the nondeductible IRA dollars to be converted to a Roth IRA tax-free (because you already paid the taxes on that money when you earned it and did not get a tax deduction upon contributing it to the traditional IRA due to your high income). If you cannot afford to convert all of your IRAs and for some reason cannot transfer those dollars into a 401(k), you can still make the nondeductible IRA contribution with the hope of being able to do the conversion step in later years when your situation may change.
The Step Doctrine
Some investors are concerned about the IRS possibly using what is known as the step doctrine to outlaw backdoor Roth IRAs. While to my knowledge this has never been done, it is a theoretical possibility. The step doctrine basically says that if the sum of a series of steps is not allowed, then the entire process is illegal even if each individual step within the series is legal. Those who are concerned about this usually wait a few months, or even a year, between the contribution step and the conversion step. That way, it is easy to argue to the IRS that the primary purpose of the nondeductible contribution was not to simply contribute to a Roth IRA “through the back door.” After five years of thousands and thousands of people funding a Roth IRA this way, I think the IRS would make a statement about it if they cared. If Congress would simply eliminate the income limit on contributions, it would simplify things greatly for investors and the IRS. Thus far, Congress seems quite happy with the increase in Roth conversions because it has increased government revenue, at least in the short run.
The final part of using a backdoor Roth IRA is to ensure your taxes are properly filed at the end of the year. Each spouse will need to complete a separate Form 8606. Occasionally, an investor or tax preparer will mistakenly pay taxes twice on the $5,500 contributed to the IRA. It is worthwhile to check your form to ensure you did not do this. Line 15 and line 18 should be $0, not $5,500. This form is kept most straightforward if the conversion is done in the same calendar year as the contribution.
The primary benefit of making a personal and spousal backdoor Roth IRA contribution each year is that a significant portion of your retirement assets can then be withdrawn completely tax-free in your golden years. Withdrawing some of your money from tax-deferred accounts and some from tax-free accounts gives you additional control of your effective tax rate, a concept referred to as tax diversification. If you were not making these contributions, that money would be in a completely taxable account instead. Done properly, you are not choosing between a tax-deferred and a tax-free account. You are choosing between a taxable account completely accessible to your creditors and a tax-free account with significant asset protection benefits in most states. That’s an easy decision.
Including a backdoor Roth IRA in your saving and investing plan will help minimize your taxes, maximize your asset protection, and grow your money faster. If you are not currently doing this, discuss it with your financial advisor or tax professional at your next meeting.
Are you doing a backdoor Roth IRA? If not, why not?