IRAs, or Individual Retirement Accounts are a great way for Americans to save for their retirement, with several different retirement accounts being available. Roth IRAs, for example, are great for high-income professions such as doctors and physicians who anticipate retiring in a high tax-bracket, due to tax free withdrawals.
The Internal Revenue Service (IRS) allows any individual with earned income, such as W-2 wages and self-employment income, to contribute to their Individual Retirement Account (IRA). These contributions are in addition to any employer retirement contributions from your employment.
For 2022, the maximum annual contribution is $6,000. However those over 50 have a contribution limit of $7,000 annually.
These contribution limits apply to all your IRA accounts, meaning if you own both a traditional IRA and a Roth IRA your total limit is $6,000 or $7,000, depending on your age. You can choose to split your allowance between each account, but you cannot go over your annual limit.
Let’s delve into the differences between the Traditional IRAs and Roth IRAs and which strategies you should be taking advantage of to benefit your future self.
For more information on how to avoid taxes during your conversion, check our in-depth guide here.
Traditional IRA vs Roth IRA
Although similar in many aspects, Roth IRA strategies allow greater flexibility and autonomy for the owner, being less restrictive than a traditional pre-tax IRA.
Both traditional and Roth IRAs grow tax-free, the Roth IRA strategy you use will determine the differences.
Traditional IRAs are funded with dollars that are yet to be taxed (pre-tax dollars). Roth IRA contributions on the other hand, are funded by post-tax dollars meaning you have already paid tax on those funds. However, deposits into traditional IRAs will grant the contributor a tax deduction on their annual tax return to incentivize saving for retirement.
As there are differences with funding, withdrawals will follow the opposite trend. Traditional IRA withdrawals will be taxed at the time of distribution whereas Roth IRA withdrawals are distributed completely tax free since the funding was with post-tax dollars.
There are certain potential penalties associated with withdrawing funds from traditional and Roth IRAs.
For traditional IRAs, a 10% penalty will be incurred if you withdraw the funds before the age of 59 ½ with the full amount being taxed as it was funded with pre-tax dollars.
With a Roth IRA, to negate a fixed 10% withdrawal fee you must meet the following guidelines.
- Any withdrawal happens after you are 59 ½
- Withdrawals occur after a minimum hold of five years
However, there are a few exceptions to avoid penalties such as if you’re buying your first home, paying birth or adoption fees or paying for education expenses. You have a lifetime home withdrawal allowance of $10,000.
Roth IRAs withdrawals are tax free if you meet both requirements stipulated above. If you are over 59 ½, but have not held the funds for more than five years, your earnings will be taxable.
Required Minimum Distributions
Unlike a traditional IRA, Roth IRAs have no Required Minimum Distribution (RMD) and can be held indefinitely and even passed onto your beneficiaries tax-free. RMDs are required for Traditional IRAs and are the minimum amount a person of age, currently 72, has to withdraw from their IRA each year.
What is a Backdoor Roth
A backdoor Roth IRA is luckily not another type of individual retirement account, but a process for high-income earners to create a tax-free Roth IRA even if their income is over the limit for direct Roth contribution.
In 2022, your Gross Income must be less than $144,000 to contribute funds towards a Roth IRA. For married couples, your joint gross income must be less than $214,000.
Backdoor Roths are used to allow high-income earners, who are legally phased out of contributing to a Roth IRA, to circumnavigate legislation through the utilization of traditional IRAs, where there are no income ceilings for contribution. Conversions charge tax on any funds deposited with pre-tax dollars, and any earnings.
How Do You Perform a Backdoor Roth
A very thorough guide has been created on how to successfully perform a backdoor Roth here.
To be put simply, backdoor Roth IRAs can be achieved in one simple way:
- Contribute funds to a pre-tax IRA and roll over the funds into a Roth (post-tax) IRA
(There are no restrictions on how you can convert a traditional IRA to a Roth IRA – cash or in-kind assets)
The 5-Step Process
- Initial Contribution into your Traditional IRA
At the start of every tax year, January 1st onwards, contribute the maximum amount of $6,000 into your traditional IRA ($7,000 if you are over 50). To minimize any hassle with paperwork, it is recommended to contribute and complete your conversion in a short time span – so plan accordingly.
The funds for your contribution will come from your personal bank account. Remember this is an Individual IRA and not a business retirement account. It can never be a deduction for your business. Also, remember the contribution is being done with post-tax dollars so you have already paid tax on the contribution!
- Do Not Invest The Contribution!
Contributions in a traditional IRA are usually put into specific funds to earn interest or grow the funds. However, if you invest those funds in your traditional IRA before converting it to your Roth IRA, you risk accumulating growth in the account and any growth will be taxable upon conversion to the IRA. The principal will not be taxable but the growth will be taxable.
- The Conversion
Using the same brokerage account, convert your traditional IRA funds into the Roth IRA. It is recommended to do this conversion the next day after the contribution to avoid any growth in the account that would be taxable upon the conversion. Some companies may make you wait a few days or a week.
Do not panic if the website prompts you to let you know this event is taxable, you have already paid taxes on the initial contribution because of your high-income status. You will want to make sure you do not withhold any taxes on the conversion either.
- Now You Can Invest
If you already have an investment plan inside your Roth IRA, you can simply add the additional funds into it.
Otherwise, either choose to leave it in cash (which is not recommended as you will not grow your funds quickly) or select an investment which matches with your investment philosophy.
- Reap the Rewards
Now your after-tax dollars are inside your Roth IRA, you can relax knowing whenever you withdraw these funds after the five year holding period, they will be completely tax free regardless of your tax bracket.
The five-year rule does not reset when a conversion is made, and is based on the initial contribution of funds to a Roth IRA.
However, you must be aware of the Pro-Rata Rule which requires all other IRA balances, such as from your traditional IRA, SEP IRA, or SIMPLE IRA to be zero, otherwise you can risk losing the tax-free conversion benefit of a backdoor Roth IRA.
Extra comments: You are also required to fill out IRS Form 8606 each year with your individual income tax return
Your backdoor Roth should be done between January 1st of the current tax year and before the filing of your individual tax return (generally, April 15th). It is recommended to contribute to your traditional IRA and do your Roth conversion as early as possible in the current year to take full benefit of non taxable gains in a Roth IRA and to give your contributions more time to grow.
Advantages and Disadvantages of a Backdoor Roth
However wealthy you are, any excess retirement funds are always great to have.
- Any growth and withdrawal of your Roth IRA funds will be completely tax free. $6,000 each year may not seem like a lot, but once they begin to compound on each other you may be surprised.
- There is no set time where funds must be withdrawn
- Roth IRAs are great for estate planning, allowing your kids or grandkids to inherit the money with no tax consequences.
Retirement accounts have some downsides such as:
- Unable to utilize margin investing
- Unable to withdraw earnings before you reach the age of 59 ½ without incurring a 10% penalty.
- Requires the conversion of any traditional IRAs balance into a 401(k) in order to avoid pro-rata rules (however, this can be done tax-free) or into a Roth IRA which would result in tax due at your current tax rate.
Astonishingly, some extremely high-wealth individuals believe this simple process is not worth the benefit of an extra $6,000.
Who would be a good candidate for a backdoor Roth.
High income earners are the main candidate for a backdoor Roth, as the contribution allowance for those earning above six figures begins to be phased out.
For this reason, backdoor Roth IRAs for doctors and physicians are extremely popular, especially considering they are expected to increase their earnings the more experience they gain in their field.
Those who have maxed out other retirement saving options and choose to perform a backdoor Roth IRA should be willing to not touch the funds for at least five years.
High-income earners such as physicians and other business owners should take advantage of legal loopholes to create an even larger, tax free retirement cushion for themselves. Although you may be a high-income earner now, the future is never promised, so taking steps to secure financial freedom when you decide to retire is a no-brainer!