There are many healthcare professionals who would benefit from contributions to a Roth IRA so that they have money to withdraw tax-free in retirement, but the IRS rules prevent them from doing so because their incomes are too high. If you fall under these rules, fear not, as there are other ways to build up that tax-free nest egg. For the tax year 2020 the IRS begins to reduce allowable contributions to a Roth IRA if you are married filing jointly and your modified adjusted gross income exceeds $196,000. They completely eliminate your ability to contribute once it reaches $206,000. If you are filing your taxes married separately as part of your student loan debt strategy, the income limit plummets to $10,000. If you fall above these limits you still have other options you should consider.
1) Check to see if your employer 401(k) or 403(b) allows Roth contributions. There are two big benefits to this option. The first is that there is no income limit. Anybody who is actively contributing to a 401(k) or 403(b) that makes Roth contributions an option can do so. Another benefit of making Roth contributions inside of a 403(b) is that you are able to put a lot more in each calendar year. Just like pre-tax contributions, for 2020 you can contribute up to $19,500 as Roth contributions if you are under 50 years old. In contrast, the 2020 limit for a Roth IRA is $6000 if you are under 50. Just keep in mind that if you are making Roth contributions, any employer match that you are eligible for will still be in the form of pre-tax dollars. Another thing to be mindful of is that if you are used to getting a tax deduction for making all of your contributions on a pre-tax basis, and you are also used to getting a big tax refund each year, that refund may look a lot different when you switch to roth contributions. This isn't a bad thing as its almost always better not to be getting a giant refund.
2) If your employer doesn't offer Roth contributions as an option in their plan, then you can go at it another way, through the backdoor. A backdoor Roth is where you make a non-deductible contribution to a traditional IRA first, then take all of that money out of the traditional IRA and move it directly to a Roth IRA. We will walk through the specific steps below.
- Make a non-deductible traditional IRA contribution. Your spouse can do the same thing for themselves even if they don't have any earned income. Non-deductible means you are making the contribution with after tax dollars so it doesn't help you reduce your taxable income for the year like a normal traditional IRA contribution does. You can use the same traditional IRA each year for this purpose. Beware the Pro-Rata Rule!
- If you don't already have one, you also need to open a Roth IRA with the same company as your traditional IRA, and transfer what you just contributed in your traditional IRA over to the Roth. Again, you can use the same Roth each year. The key here is that you will not owe taxes on this transfer because the money had already been taxed once, before it went into your traditional IRA. To keep things simple the best approach is to make the entire year's contribution to your traditional IRA sometime in January, and then after a day or two move it all to the Roth. Some people think its better to do these transfers in chunks throughout the year or they make the traditional IRA contribution, but forget to transfer it to the Roth until the following year. This makes doing your taxes more difficult.
- Invest the new Roth IRA money. This is a common, yet costly mistake. The biggest benefit of the Roth is tax free GROWTH. But most companies will initially place your money in a conservative cash-like position when it first arrives in the account, which earns close to zero percent interest. If you don't take steps to invest it in something more growth oriented like a stock based ETF or mutual fund, you have defeated the purpose.
- You or whoever files your taxes for that calendar year must include form 8606 on your taxes. You will need one for each spouse. This can be done with turbo tax but make sure you take the time to fill it out correctly. This form is what is used to prove to the IRS that you did take money out of a traditional IRA, but unlike normal traditional IRA distributions which are taxable, yours is not because it was funded with after tax money. You (and your spouse if applicable) will have to fill this form out each year that you do a backdoor Roth contribution.
- Rinse and Repeat. You should follow this process every year in January. Don't try to get cute with trying to time your contributions with what you think the the performance of the stock market will be like.
The backdoor Roth can be a great retirement savings strategy for healthcare professionals, but like most things in financial planning, the benefits and drawbacks are unique to each individual. Before making the decision to do this you may want to consult a professional who is able to analyze your situation holistically and help you decide if it make sense for you.