IRAs-Back to Basics Series
Truthfully, most physicians have about zero use for a traditional individual retirement arrangement (IRA). In residency, they should be doing Roth IRAs and later in their career, they make too much money to deduct their traditional IRA contributions. But it is still worthwhile understanding how a traditional IRA works as it is the basis for understanding other, more useful types of retirement accounts, such as backdoor Roth IRAs, converted IRAs, rollover IRAs, 401Ks, SEP-IRAs, stretch IRAs etc.
A traditional IRA allows you to contribute up to $5000 a year of earned income for you and another $5000 for a non-working spouse. After age 50, you can make an additional $1000 “catch-up” contribution each. If you are covered by an employer’s retirement plan, such as a 401K, you can only deduct these contributions if your income is under $66,000 (single) or $110,000 (married.) That disqualifies most physicians and those who aren’t disqualified should probably be using a Roth IRA. If you aren’t covered by an employer’s plan, there are retirement plans out there (such as a solo 401K or SEP-IRA) that allow for much larger contributions which should probably be used if at all possible.
The money in a traditional IRA grows tax-free. If you withdraw the money prior to age 59 1/2, you will have to pay an additional 10% tax as well as any income tax which would be owed on the money. After that age, you just have to pay the income tax. Once you hit age 70, you are required to start withdrawing part of the money each year, the “Required Minimum Distribution (RMD).” This is age based and starts out at about 3.6% and increases to about 8.8% at age 90. That is one benefit of Roth IRAs over traditional IRAs-Roth IRAs have no RMDs.
Traditional IRAs can be opened at just about any bank, brokerage firm, or mutual fund company. You can invest in most publicly traded securities including stocks, bonds, mutual funds, or CDs. There are even ways you can make private investments, including real estate, in an IRA. You cannot invest on margin in an IRA. You cannot take a loan from an IRA (unlike a 401K). An IRA is generally protected from creditors. Contributions for any given year must be made between January 1st of that year and April 15th of the next year.
It is important to understand the difference between accounts (taxable, traditional IRA, 401K) and investments (stock, bond, CD, or mutual fund). Consider accounts as types of luggage and investments as types of clothes. You may need a different type of luggage for a different type of trip. But you can just as easily put a t-shirt inside a backpack as a suitcase or a carry-on. You can also put an investment inside many different types of investment accounts.
The traditional IRA is the basic framework for all retirement accounts. A solid understanding of how it works will allow you to understand all your other retirement accounts. You can get more details from IRS Pub 590.
I love your website. Genius. I am an ophthalmologist 3 years out of fellowship and have many questions but I will keep it simple. I max out my 401k which I have had for one year with John Hancock. It has 28000 after this year. I figure I should do an IRA next and convert to Roth. My question is why are there limits to Roth when anyone can convert from traditional IRA?
I have emergency fund of 35000 sitting in checking account. Does that need to be placed in another location?
Thank you for your advice and the time you take to run the website. Honestly I’d feel more comfortable with you managing my money than others!
Thanks for your kind comments. The backdoor Roth IRA is simply a loophole. Take advantage while you can. Don’t expect it to make sense.
I’d probably take half your emergency fund and put it in an online savings account like Ally Bank. You’d make 1% instead of 0%, but it isn’t going to make a huge difference- about $175 a year or so.
Thank you for your response. The other question I have is how many iras do people typically have since you can only put 5000 a year into one. I know this would be advantageous come retirement but it seems to pale in comparison to how much is typically in a maxed out 401k even if it is converted to a Roth.
Would this be the next best investment for retirement especially in the range of the numbers given?
Do you mean how many IRA accounts or how much money in IRAs? I don’t understand your question.
Both actually. Can you have several at 5000 apiece or just 5000 max total split up into several different IRAs. What I am getting at is what is the next biggest investment for retirement after a 401k in terms of dollar amounts?
It’s $5000 total into all IRAs per person per year. It actually goes up to $5500 in 2013. If you’re over 50, it’s $6500.
Keep in mind that 401Ks and IRAs aren’t investments. Investments are what you put inside of them. 401Ks and IRAs are accounts.
Other types of accounts people use for investing include taxable accounts (no limits), 401K/profit sharing plans ($51K in 2013), 403B ($17K), 457 ($17K), HSA ($6450 family), defined benefit plan (limits vary) etc.
WCI, Love the blog.
A couple questions. Going to be graduating from fellowship and will be an indepedent contractor starting in August and want to really reduce my tax liabilty as I am single. I won’t make enough money to max out SEP-IRA contributions so I was thinking about opening individual 401K and maxing out then doing a traditional IRA with backdoor Roth conversion. I will be also be responsible for my own health insurance, should I also set up an HSA, does this effect my effective tax rate?
You catch on fast SK. You will be able to shelter more money into a Solo 401K than a SEP-IRA assuming you can’t max out the SEP-IRA. This assumes you didn’t have a defined contribution plan to which you made employee deferrals as a fellow. You can also do Roth contributions to the Solo 401K, which may be a good idea this year since you’ll only have 5 months of attending-level income, but probably not after that. You can also put $5500 into a non-deductible traditional IRA and convert it to a Roth. Remember, if you use a SEP-IRA and don’t convert it entirely by the end of the year, it’ll screw up your pro-rata calculation for the backdoor Roth.
You can also use an HSA, as long as you have a HDHP. It will lower your effective tax rate. It basically lowers your taxable income by the amount you put into it (up to $3250 for 2013.) If you have a combined state and federal marginal rate of say 33%, that’ll save you something like $1073 off your 2013 tax bill.
Hello, I am a physician, so I do not qualify for a roth IRA. If I want to open a roth IRA, I have to open a non-deductible traditional IRA and then converted to roth. The question is, how do I open a NON-DEDUCTIBLE traditional IRA?
Every company I go online, there is the option of a “traditional IRA,” but it does not specify if is a deductible account vs a non deductible account. I don’t want to open one of these “traditional IRAs” only to end up being a deductible account.
Thank you,
It’s a traditional IRA. You just don’t get a deduction for it. Thus a “non-deductible” traditional IRA.
Thank you!
Great site. Ive been reading your site for about 6 months now and finally have a post. Ive recommended it to several friends, but they all already knew about it! Congrats on the popularity Have you though about writing a book.
My question/comment is: I just graduated from residency June 2013. My wife (Physician Assistant) had a 401K and I had a 401A before moving to start a private practice job as an employee. The combined total is 80K for the 2 plans. Ive read Four Pillars (Bernstein), Some of The Intelligent Investor (Graham) and am listening to A Random Walk Through Wall Street. I’ve picked out an asset allocation (the clothes) but now I’m struggling with the retirement plan (the luggage) to rollover into. I should make partner in 2 years and my wife is working partime. I have a High deductible health plan and have looked into Health Saving Administrators for an HSA. Id like to save $3750 a month for retirement. What type of plan(s) should I be looking at?
Also I should add that neither my wife or I have retirement plans with the current employers.
Yes, I’m definitely thinking about a book.
Your luggage has already likely been determined by your partnership, no? For instance, my partnership has a 401K/profit-sharing plan with a $51K/year contribution limit and a defined benefit plan with a $15K/year limit. We also do a personal and spousal backdoor Roth IRA (another $11K) and an HSA ($6450) and a solo 401K for this blog.
What is your partnership’s plan? You say they don’t have one, but I’m having a hard time believing it. Really? Why not get your partners together at your next meeting and start one? Perhaps a 401K/profit-sharing plan through Employee Fiduciary. Or are you partners only in a medical sense, and not in a business sense (it would seem not since you talk about “making partner.”)
If you’ll be eligible for a plan soon, you could use your current savings to do backdoor Roth IRAs and do Roth conversions of some of your old retirement money.
If neither of you have an employer-arranged retirement plan, and you’re both employees, you’re kind of hosed. You can’t open a SEP-IRA (or better a Solo 401K) if you’re an employee. You may be stuck with the HSA, backdoor Roths, and a taxable account. That sucks. Here’s an article on 401As you might find useful.
https://www.whitecoatinvestor.com/401-a/
Thanks for the reply. The partners have mentioned that they have a SEP plan. I’m not sure when I would be eligible however as there are some requirements for working a certain amount of years I thought (3 of the last 5 maybe). That would mean that I’m stuck without one for a bit more and I wanted to contribute maximally now to tax-deferred. My wife is part-time so she wont have benefits. Why cant I open a traditional-IRA? I could deduct the contributions since I don’t have an employer plan right? Also, why do a Roth when I’ll probably be in a lower tax-bracket when I retire (were in 33% marginal now)?
I know that’s still only 11K for myself and spouse for the IRA and $6450 for the HSA for family, so basically I need the SEP or 401K so that I can save my goal of 45K/year without using taxable accounts right? I think I need to have meeting with the partners…..
First, find out exactly when you’re eligible for the SEP-IRA. I doubt it’s more than about a year you have to wait. Second, when you’re able to, you may want to encourage others in your group to change to a different plan. There are several reasons a SEP-IRA is inferior to a 401K. Here’s a post on it:
https://www.whitecoatinvestor.com/sep-ira-vs-solo-401k/
It would be great if you can get that changed soon so you can do a backdoor Roth IRA even after you start contributing to it.
Third, you can open a traditional IRA but despite not having a plan at work you’re eligible for, you still can’t deduct it because you make too much.[Not true, see comments below. Not sure what I was thinking when I said that.] You can still do backdoor Roth IRA however.
Fourth, you do the Roth despite probably having a lower marginal tax rate later because it beats the pants off a taxable account, which is your alternative. You’re not choosing between tax-deferred and Roth. You’re choosing between taxable and Roth.
Fifth, be careful in meeting with your partners. Remember that the most important thing is to actually make partner! There are worse retirement accounts than a taxable account. You can also use the time while you’re waiting to have access to the partnership retirement plan to pay down student loans or save up a home downpayment or build up your emergency fund etc. Many docs have trouble putting a lot toward retirement that first year or two due to shorter term financial needs.
Hope that helps.
Ok, I’m confused. I feel like a first year resident again.
According to IRS publication 509 on the Traditional IRA:
http://www.irs.gov/publications/p590/ch01.html#en_US_2012_publink1000230505
See Table 1-3: if I’m married filing jointly and neither myself nor my wife have a retirement plan at work (which we don’t), I can fully deduct all Traditional IRA contributions (at my 33% current marginal rate). If this is the case then why would I want to do a Backdoor Roth if I’ll possibly be in a lower tax bracket in retirement? It seems that for the $5500 I’m allowed in total IRA contributions in 2013, the choice is between tax-deferred (traditional IRA) and Roth. What am I missing?
Here’s the relevant section from Pub 590:
So you’re right, you COULD do a deductible traditional IRA for 2013 as long as you didn’t have a retirement plan at work or for self-employed work at any point in 2013. Same for your spouse. Otherwise, the income limits apply and you’ll have to do backdoor Roth IRAs.
Hello, a little late and this May have already been mentioned elsewhere but what is the difference between the SEP-IRA and the solo 401k and how do I know which one I am eligible to participate? I am an employee at one job with W2 and 401k through the job, but I also work as contractor for another hospital and receive a 1099.
https://www.whitecoatinvestor.com/sep-ira-vs-solo-401k/
You probably want a solo 401(k). You’re eligible for both.
Thanks for getting back to me. I’m still a little confused about why I would choose one over the other. Sounds like SEP-IRA would be easier but solo 401k wouldn’t have hassle of the pro-rata involved with the back door Roth?? You mentioned that you have had several SEP-IRAs…so do you convert them to back door roths every year?
I’ve converted my SEP-IRA to a Roth IRA and now use an individual 401(k).
I am so confused maybe you can enlighten me.
Both husband and I are physician but I took many years off to raise families. During those years, we open a spousal IRA. Then I went back to work, like 1 weekend a mth and for that I have 1099. My husband has W2 – he has 401k from work and defined benefit. I started to open Sep IRA – so now I have spousal IRA, sep IRA and when I used to be in training, 403(b). I donno what to do with all these accounts ? I would love to streamline them. Help !!
You CAN streamline them, but may not want to. If I were you, I’d open an individual 401(k) and roll your spousal IRA and SEP-IRA, and 403B in there. Then you use your IRA as a conduit for backdoor Roth IRAs each year. Search those terms on the site and read more about each of them.
I have been out of residency for about a year and a half and have been in the process of rolling over my wife’s and my 401(k)s from my residency and her former job as a physician’s assistant. Due to what we have accrued, the total conversion to a backdoor Roth this year will leave us with a tax burden of about 35K, per our CPA. Due to other upcoming expenses we would probably have to dip into our 6-month emergency fund to pay that off. Our CPA recommends rolling it back into traditional accounts and keeping it all there whereas our financial advisor recommends leaving it in the Roths and paying the taxes. I am torn about what to do and was wondering what you would do in this case. I had also considered gradual partial conversions or paying it next year albeit with a higher cost due to gains.
The easiest thing to do is roll it into your new 401(k) or leave it in your old 401(k). No tax bill, and you can still do a backdoor Roth. If that’s not an option, I might just bite the bullet and convert it all. It would have been better to do that in a lower income year, such as the year you finished residency. What I think is a poor choice (for high earners who must do their Roth IRA contribution through the backdoor) is rolling it into a traditional IRA.
What are your thoughts on how the RMD can jeopardize your retirement savings compared to the more popular 4% rule? If the 4% rule gives you a >90% chance of success of your money lasting 30 yrs, will RMD having a potential larger % withdrawal rate in the later stages increase the possibility of outliving your savings?
I think an RMD approach is probably just fine. The truth is the matter is that one mechanical rule is probably a dumb way to do it, no matter what the rule is. Just adjust as you go. Want to spend more? Annuitize some of it.
I have a simple question re: IRAs. why physicians or high income individuals should prefer roth IRAs vs traditional IRAs? and do I need to have opened a traditional IRA before creating the ROTH-IRA option (then move to the back door IRAs?
Thanks in advance.
Attending physicians usually can’t deduct a traditional IRA contribution whereas they can do a Backdoor Roth IRA. That’s why. Here’s more info on how to do a backdoor Roth IRA.
https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
I just started working as an attending physician and have never had a IRA before. Based on my current anual income I would not be eligible for a pure Roth IRA. Based on the link you recommended, it seems that I would first need to create a traditional IRA account (no income limit) then do a backdoor-roth account? and just to clarify: is the term “backdoor” referring to a Roth-IRA it self or it applies for any switching accounts (eg. transferring money from a roth IRA to a “backdoor traditional IRA?)
Thanks a lot.
I don’t know what a backdoor traditional IRA is. The backdoor refers to the indirectness of the transaction. Rather than contributing directly to a Roth IRA (not allowed for a high earner) you have to do it indirectly by contributing to a traditional IRA (allowed) and converting that traditional IRA to a Roth IRA (also allowed.)
Details here: https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
My wife recently wanted to help out a friend who just got a job with Ameriprise so she let her mange her 403b from a previous job. Unfortunately, she just converted it to a traditional IRA and so now we have $40K in an IRA with Ameriprise (with its high fees). This was all done before I became a WCI follower (A Dahle Devotee if you will). I am getting ready to start a relatively high paying attending job (narrowed down to two jobs) and I was wondering what I should do with the money. I feel like my best two options are covert it all to a Roth IRA 9and pay the taxes/fees associated with that) or wait until I get my job and see if I can put a lump sum into my employer 401k.
If anyone has any suggestions or other ideas, it would be greatly appreciated!
That was a nice way to help out a friend. Why not just give her $1000 next time? Probably cost you less and give her more. At any rate, that’s water under the bridge now.
Sorry, you’ve got to move this money away from Ameriprise eventually. Might as well be sooner instead of later.
The year you graduate from residency is a great time to do a Roth conversion, but if you don’t have the money or have a better use for the money, rolling it into a 401(k) will also allow you to do future backdoor Roth IRAs.
What’s the best company to do an IRA with?
I prefer Vanguard as my usual default, but there are some unusual circumstances that might cause you to want to do one somewhere else.
To clarify it seems that Traditional IRA to Roth IRA is a conversion, Roth IRA to Traditional IRA is a recharacterization. Correct?
I think you can recharacterize a traditional IRA to a Roth IRA as well.
https://www.irs.gov/retirement-plans/ira-faqs-recharacterization-of-ira-contributions
A recharacterization is simply an “Oops! That was supposed to be a contribution to the other type of account.” A conversion is typically a taxable event where you decide to prepay your taxes.
Ah. Thank you!
Does it always make sense to covert to a Roth IRA? I am about 3 years out of training and my current income puts me around 95% for my specialty. There is a good chance that if I take another job later in my career that I will be making less money and in a lower tax bracket. Does it still makes sense for me to convert from a Traditional to Roth IRA? Thanks!
What is the cost of converting? It doesn’t “always make sense” but if it allows you to start doing tax-free Backdoor Roth IRA conversions then it often does.
I’ve only contributed to a Roth for the past two years so just a little over 12K at the moment. Using a conversion calculator it looks like it would be an additional 4400 in taxes due? Not sure if that makes sense; my knowledge with this stuff is not the best.
Only $4400? I’d probably just convert it rather than trying to roll it into a 401(k) to allow for Backdoor Roths.