As a physician, all that delayed gratification through med school and training finally pays off when you pull in that first BIG paycheck. Unfortunately, your new salary likely prevents you from being able to make a Roth IRA contribution, because it pushes you above the IRS income limits. Thankfully, there is an alternative way to get your hard-earned dollars into a Roth IRA every year, via what is commonly known as a backdoor Roth IRA contribution. In this article, I will show you how we help our clients complete a backdoor Roth IRA contribution in five steps.
Step 1: Roll existing tax-deferred IRAs into an employer-provided retirement plan**
This first step is extremely important to do to avoid taxation on the eventual Roth conversion in Step 3. Consult the IRS’s pro-rata rule on Roth conversions to learn more.
Existing tax-deferred IRAs include Traditional, Rollover, SEP, and SIMPLE IRAs. Your workplace 401(k) or 403(b) plan will likely accept rollovers of these account types. Contact your workplace retirement plan administrator or Human Resources to learn more about starting the rollover process. If you don’t have a workplace retirement plan because you are an independent contractor and earn 1099 income, then you can set up your own solo 401(k), and roll your pre-tax IRAs there. Consult a financial advisor or tax professional first.
Once all of your pre-tax IRAs have a zero balance, then you are ready to move to step 2. You can keep your existing Roth IRA just as it is, even if it has a balance. You do not need to roll it over.
Step 2: Make a non-deductible contribution to a traditional IRA**
To do this, you need to open a new traditional IRA or use an existing IRA that’s still open with a zero balance. The financial platform you use should have a way to electronically transfer money from your existing bank account to your IRA.
It’s important to remember that IRA contribution limits are subject to change each year. So your first priority is to find the current year maximum IRA contribution via online search (for 2024 it’s $7,000, with a $1,000 catch up for anyone 50 and over).
**Important note: If you are over the contribution income limit, you won’t be able to deduct your contribution on your taxes. We call this a non-deductible contribution. That’s ok though, because this means the eventual Roth conversion will not be taxable (since it’s already been taxed). However, you will need to keep track of the fact that it’s a non-deductible contribution, because your financial platform won’t. We’ll talk about how to how to do this in Step 5.
**Tip: I don’t recommend investing your contribution until you convert it to your Roth IRA (step 3). The best way to keep the accounting clean throughout this process is to convert the exact same amount that you contributed. Keep it uninvested, until after you’ve converted it to a Roth IRA.
Step 3: Convert your traditional IRA balance to a Roth IRA**
If you have an existing Roth IRA on the same financial platform as your traditional IRA, you can use it for this part of the process, even if it has a balance. If you don’t have an existing Roth IRA on the same platform, you’ll need to set up a new one.
Before we review how to do initiate a conversion, we need to first discuss how long you should wait between contribution and conversion. You will hear different things from different thought leaders on this.
Michael Kitces argues that for you to be totally safe, you should wait a year between contribution and conversion. The reason being, that while the two-steps of a back-door Roth Contribution aren’t illegal, the combination of both done in rapid succession could be perceived as a way to circumvent the law, which could get you in trouble with the IRS and/or Tax Court.
A blog at Ed Slott and Co says that a one month waiting period is recommended and sufficient to prove that the transactions are separate.
Jim Dahle at White Coat Investor dared the IRS to audit him on his backdoor Roth IRA (even though he converts it the day after making his contribution), to no avail.
It’s up to you how you want to go about it, but for further consideration, Congress appeared to bless the backdoor Roth IRA process, no matter the waiting period.
Once you’ve waited to the point you’re comfortable with, move forward with the conversion. The amount should be the same as your contribution. You will need to ask your financial platform how to do this, as every custodian is different. The most direct way is to call customer service to ask for help. Some financial platforms will allow you to initiate a conversion at the click of a button, while others will require a formed to be signed.
The contribution and conversion are best done in the calendar year. Contributing to your traditional IRA and/or converting the contribution to your Roth IRA after December 31st for the prior year can make the filing of Form 8606 (step 5) a messy process and inconsistent from year to year. So, best practice is to contribute and convert in the same year that applies to your tax return.
**Important note: Your financial platform may tell you that the conversion is a taxable event. But what they don’t know is that you made a non-deductible contribution, and therefore the money sitting in your IRA has already been taxed. As long as you have followed the steps correctly, converting the IRA won’t be a taxable event, despite what your custodian is telling you. Just make sure that you rolled all your other pre-tax IRAs over to your 401(k), first. Always consult with your tax professional first to confirm.
Step 4: Invest*
Once you’ve completed the conversion, then you are free to invest the Roth IRA according to your investment strategy. Since the money in the account and all the future earnings will never be taxed again (so long as you satisfy the proper distribution rules), you have pretty good incentive to be aggressive, to try to grow it as much as possible. But it also depends on your other circumstances. Always make sure you seek qualified advice from an competent financial advisor, if you’re unsure what you’re doing in this area. Our firm provides comprehensive investment management services to our physician clients.
Step 5: Record the process on your taxes correctly (using form 8606)**
For the tax year in which you made the contribution, you have to be very careful to file your return correctly, or you could get taxed painfully twice on the conversion amount. So please pay close attention!
You need to use Form 8606 to show that you made a non-deductible IRA contribution, which was eventually converted to your Roth IRA. The reason Form 8606 is so vital is that it shows the amount being converted is post-tax, thus not requiring additional taxation. Your accountant should take care of filing this form for you, but make sure you discuss it with them beforehand. Still, many accountants are unfamiliar of the backdoor Roth IRA strategy, and the tax reporting forms they receive from you will make them think you have made a taxable distribution. Make it a priority to discuss what you did with your accountant each year.
**Tip: To help make your accountant’s job easier (or your own if you file your own taxes), you will want to make the contribution and conversion in the same tax year. Most physicians will tend to contribute and convert early in the year like in January, or at the end of the year in November or December. It’s just a matter of preference.
Once you’ve filed form 8606 correctly, you’re all set! At least this time around. You can repeat this process every year (as long as tax laws remain the same). You can also repeat this process for your spouse, even if they don’t have a job and earn income. That adds up to A LOT of tax-free retirement savings! And that will go a long way in helping you achieve an earlier financial independence.
We have helped process thousands of backdoor Roth IRA contributions for our physician clients, as a part of their financial strategy. If you’d like to schedule a complimentary consultation to learn more about how we can help you, please click “Work with Us” at the top.
*Investment returns are not guaranteed. Investing in securities involves risks, including the potential for loss of principal.
**This is not intended to be tax advice. Please consult your tax professional before attempting a backdoor Roth IRA contribution.
The foregoing content reflects the opinions of Panoramic Financial and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Panoramic Financial does not give tax or legal advice. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.